Description
Documentation describes the role of gold in the Indian monetary system. It also explains the factors influencing the price of gold.
A Perspective On “Role of Gold in Indian Monetary System”
Role Of Gold In Indian Monetary System
Acknowledgement
We would like to express our deep and sincere gratitude to our beloved Director Mr. K.S. Subramaniam for giving us this opportunity to complete our research project.
This acknowledgement can’t be completed without conveying our sincere gratitude to Professor Anant Gupta (Deputy Director & the Head of Department, Finance, SCMHRD) for providing us with right direction and opportunity to complete our research project. We would also like to thank Dr. Neha Parashar, Ass. Professor, SCMHRD, for mentoring us throughout the length and breadth of the project’s duration. Her words of wisdom and guidance at every meeting helped us to tread on the right path and helped us immensely in getting the right work done on time. Without her, this paper would have been far from complete. At last I would like to thank all the faculties, students and people who were directly or indirectly were part of this project and helped us make our endeavor, a successful one.
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Role Of Gold In Indian Monetary System
Contents
Acknowledgement...................................................................................................................... 2 Contents..................................................................................................................................... 3 Preface.......................................................................................................................................7 Chapter 1: Introduction.............................................................................................................. 8 1.1 Gold Standard:...............................................................................................................10 1.1.1 Gold Specie Standard:...............................................................................................10 1.1.2 The Gold Exchange Standard....................................................................................11 1.1.3 The Gold Bullion Standard.........................................................................................11 1.2 The Bretton Woods System.............................................................................................11 1.3 History of the New Monetary System..............................................................................12 1.4 Dollar Problems:..............................................................................................................14 1.5 Actions Underway for Change.........................................................................................14 Chapter 2: Review of Literature...............................................................................................15 2.1 Factors Influencing the price of Gold...............................................................................15 2.1.1 Weak US Dollar ........................................................................................................16 2.1.2 Growth in Demand for Jewelry..................................................................................17 2.1.3 Increase in demand for exchange traded paper backed products............................17 2.1.4 Other factors leading to the variation in Gold Prices are:.........................................17 2.4.2 Street TRACKS Gold Shares – ETF Gold fund on NYSE...............................................19 2.5 Indian Foreign Exchange Reserves..................................................................................19 2.5.1 Official Stock of Gold.................................................................................................20 2.5.2 Gold as a Reserve Asset............................................................................................22 2.5.3 India’s reserves’ position and movement since Independence.................................24 ........................................................................................................................................... 26 2.5.4 India’s Accumulation of Foreign Exchange Reserves................................................26 2.5.5 Sources of Accretion to Foreign Exchange Reserves.................................................27 2.5.6 Components of Indian Foreign Exchange Reserves..................................................27 Page 3
Role Of Gold In Indian Monetary System
2.6 Gold Market Report by Data Monitor...............................................................................28 2.6.1 Research Highlights.................................................................................................. 28 2.6.2 Market Analysis.........................................................................................................29 2.6.3 Portfolio diversification..............................................................................................29 2.6.4 Gold and the dollar....................................................................................................31 2.6.5 Consumption and Production of gold across countries..............................................31 2.6.6 Consumption of gold across BRIC nations:................................................................34 2.7 Future of gold investments in India:................................................................................35 2.8 Gold and the international monetary system – a chronology..........................................36 Chapter 3: Research Methodology...........................................................................................39 3.1 Research Objective.........................................................................................................40 3.1.1 Primary Research Objective (PRO)............................................................................40 3.1.2 Secondary Research Objectives (SRO)......................................................................40 3.2 Tools Used....................................................................................................................... 40 3.3 Sample ..........................................................................................................................40 3.4 Research Methodology:...................................................................................................41 Chapter 4: Analysis & Interpretation.......................................................................................43 4.1 Gold and inflation............................................................................................................ 44 4.2 Adequacy of Foreign Exchange Reserves.......................................................................45 4.3. India’s Concerns in Managing Foreign Exchange Reserves...........................................48 4.4 Gold and risk................................................................................................................... 49 4.5 Gold as a tactical inflation hedge and long term strategic asset.....................................50 4.6 Gold in present Market Scenario.....................................................................................51 4.7 Correlation of Gold prices with various other commodities.............................................54 4.8 Gold Mining Supply 2009................................................................................................56 4.9 Gold as tool to hedge against US Dollar currency...........................................................59 4.9 Gold's value as a currency reserve.................................................................................62 4.10 Gold Consumption in India............................................................................................65 4.11 Pattern of gold investment in India:..............................................................................66
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Role Of Gold In Indian Monetary System
4.12 The gold versus equity..................................................................................................67 Chapter 5: Conclusion.............................................................................................................. 70 5.1 Gold mining's value to developing countries...................................................................70 5.2 Gold as a preserver of value inflation hedge, safe haven...............................................71 5.3 Gold's value as a reserve................................................................................................71 5.4 Gold's value in industrial applications.............................................................................71 5.5 Gold's value as an effective portfolio diversifier..............................................................71 5.6 Gold's value to consumers and investors in developing countries..................................72 5.7 In India, you’re in gold’s own country.............................................................................72 5.8 Impacting Factors affecting price of Gold........................................................................72 5.9 Future Outlook................................................................................................................73 5.10 So, Are we moving into bubble territory? .....................................................................73 Chapter 6: Bibliography............................................................................................................74 Links:.....................................................................................................................................75 Chapter 7: Appendix................................................................................................................ 76
List of Figures
Figure 1: Global Gold Market Value----------------------------------------------------------------------------------27 Figure 2: 5-Year Correlation of Weekly returns---------------------------------------------------------------------28 Figure 3: Gold and the trade-weighted Dollar----------------------------------------------------------------------- 29 Figure 4: Production and Consumption Weighted Real Gold Pric------------------------------------------------31 Figure 5: BRIC’s Gold Consumption----------------------------------------------------------------------------------33 Page 5
Role Of Gold In Indian Monetary System
Figure 6: Bar Chart- Gold Deposits of different Income Levels---------------------------------------------------39 Figure 7: Forms of Investment in Gold--------------------------------------------------------------------------------40 Figure 8: Gold gives best Return When? -----------------------------------------------------------------------------41 Figure 9: Currencies in terms of Gold---------------------------------------------------------------------------------42 Figure 10: Annual Growth of Gold Prices-----------------------------------------------------------------------------48 Figure 11: Gold as a percentage of total Assets-----------------------------------------------------------------------49 Figure 12: Above ground Stocks----------------------------------------------------------------------------------------49 Figure 13: World Gold Mining Output Vs Gold Price---------------------------------------------------------------53 Figure 14: 2008 Gold Production---------------------------------------------------------------------------------------55 Figure 15: Gold as tool to hedge against US Dollar currency------------------------------------------------------56 Figure 16: Gold reserves as the percentage of total reserves for United States----------------------------------59 Figure 17: Gold reserves as the percentage of total reserves for India---------------------------------------------59 Figure 18: Gold reserves as the percentage of total reserves for China--------------------------------------------60 Figure 19: The GDP and the savings rate of India--------------------------------------------------------------------63 Figure 20: Gold Rush-----------------------------------------------------------------------------------------------------65
List of Tables
Table 1: World Official Gold Holdings-------------------------------------------------------------------------------19 Table 2: India’s Foreign Exchange Reserves-------------------------------------------------------------------------23 Table 3: Gold Production weighted index of countries--------------------------------------------------------------30 Table 4: Gold Consumption weighted index of countries-----------------------------------------------------------30 Table 5: Salary Vs Deposits- Cross Tab-------------------------------------------------------------------------------38
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Role Of Gold In Indian Monetary System
Table 6: Chi-Square Tests------------------------------------------------------------------------------------------------39 Table 7: Emerging Market Adequacy Reserve Ratios----------------------------------------------------------------43 Table 8: Excess Reserves of Countries---------------------------------------------------------------------------------44 Table 9: Correlation of Gold prices with various other commodities----------------------------------------------45 Table 10: Top Gold Mining Companies--------------------------------------------------------------------------------54
Preface
Central banks of countries around the world, including RBI, hold 29,634 tonnes of gold, compared to an annual world gold production of roughly 2,400 tonnes. So, their gold sales, leases and purchases have a huge impact on international gold prices. China, now the world’s biggest gold producer, has increased reserves of the metal by 76 per cent.
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Role Of Gold In Indian Monetary System Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand, including hoarding and disposal. Unlike most other commodities, the hoarding and disposal plays a much bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price. Given the huge quantity of hoarded gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production. Gold is always seen as a thing to own and only for consuming as ornaments, for jewellery but seldom as an investment purpose . Gold is unlike a bond. Gold pays no interest. But, Gold cannot become worthless like a bond can. The values of both rise and fall in free market trading. With prices falling and the economy deteriorating, investors traditionally hoard cash and near-cash safe instruments such as government bonds, money market funds and gold The belief that money market funds pose zero risk and are super safe has also been badly shaken as the credit crisis has drained liquidity, prompted forced sales and knocked down the value of such funds. Stocks and Bonds prosper in strong economic times and bear higher risks in bad times. By contrast, Gold ignores recessions and does well when these and other traditional investments fail. Gold investments also acts as an anti-currency. Here at home, Gold soars in value when the U.S. Dollar is falling. Better still, Gold loves and thrives on inflation– events that Bonds hate and destroys the buying power of cash, Bank CDs, or other debt instruments.
Chapter 1: Introduction
A monetary system is anything that is accepted as a standard of value and measure of wealth in a particular region.
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Role Of Gold In Indian Monetary System The current trend, however, is to use international trade and investment to alter the policy and legislation of individual governments. The best recent example of this policy is the European Union's creation of the euro as a common currency for many of its individual states. Modern currencies are not linked to physical commodities (silver or gold) and are not a contract to deliver a good or service. As such the value of a currency fluctuates based on politics, perception and emotion in addition to monetary policy. Apart from monetary systems based on money, there do also exist systems based on "favors". One example of this is the LETS system. LETS, or Local Exchange Trading Systems, are local community trading groups where members exchange their goods and services with each other. Monetary system is one in which the standard unit of currency is a fixed quantity of gold or is kept at the value of a fixed quantity of gold. The currency is freely convertible at home or abroad into a fixed amount of gold per unit of currency. In an international gold-standard system, gold or a currency that is convertible into gold at a fixed price is used as a medium of international payments. Under such a system, exchange rates between countries are fixed; if exchange rates rise above or fall below the fixed mint rate by more than the cost of shipping gold from one country to another, large gold inflows or outflows occur until the rates return to the official level. These “trigger” prices are known as gold points. The gold standard was first put into operation in Great Britain in 1821. Prior to this time silver had been the principal world monetary metal; gold had long been used intermittently for coinage in one or another country, but never as the single reference metal, or standard, to which all other forms of money were coordinated or adjusted. The great gold discoveries in California and Australia in the 1840s and ’50s produced a temporary decline in the value of gold in terms of silver. This price change, plus the dominance of Britain in international finance, led to a widespread shift from a silver standard to a gold standard. Germany adopted gold as its standard in 1871–73, the Latin Monetary Union (France, Italy, Belgium, Switzerland) did so in 1873–74, and the Scandinavian Union (Denmark, Norway, and Sweden) and The Netherlands followed in 1875–76. By the final decades of the century, silver remained dominant only in the Far East (China, in particular). Elsewhere the gold standard reigned. (See also Free Silver Movement.) The early 20th century was the great era of the international gold standard. Gold coins circulated in most of the world; paper money, whether issued by private banks or by governments, was convertible on demand into gold coins or gold bullion at an official price (with perhaps the addition of a small fee), while bank deposits were convertible into either gold coin or paper currency that was itself convertible into gold. In a few countries a minor variant prevailed—the so-called gold exchange standard.
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Role Of Gold In Indian Monetary System
1.1 Gold Standard:
The gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold. Three distinct kinds of gold standards can be identified. The gold specie standard is the system in which the monetary unit is associated with a circulating gold coin. The gold exchange standard may involve only the circulation of silver coins, or coins made of other metals, but the authorities will have guaranteed a fixed exchange rate with another country that is on the gold standard, hence creating a de facto gold standard in that the value of the silver coins has a fixed external value in terms of gold that is independent of the inherent silver value. The gold bullion standard is a system in which gold coins do not actually circulate as such, but in which the authorities have agreed to sell gold bullion on demand at a fixed price. 1.1.1 Gold Specie Standard: A gold specie standard existed in some of the great empires of earlier times, such as in the case of the Byzantine Empire in conjunction with the gold Byzant coin. But with the ending of the Byzantine Empire, the civilized world tended to use the silver standard, such as in the case of the silver pennies that became the staple coin of Britain around the time of King Offa in the year 796 AD. The Spanish discovery of the great silver deposits at Potosi in the 16th century, led to an international silver standard in conjunction with the famous pieces of eight, which carried on in earnest until the nineteenth century. In modern times the British West Indies was one of the first regions to switch to a gold specie standard. The gold standard in the British West Indies, that followed from Queen Anne's proclamation of 1704, was based on the Spanish gold doubloon coin. In the year 1717, Sir Isaac Newton, who was master of the Royal Mint, established a new mint ratio as between silver and gold that had the effect of driving silver out of circulation and putting Britain on a gold standard. But it wasn't until the year 1821, following the introduction of the gold sovereign coin by the new Royal Mint at Tower Hill in the year 1816, that the United Kingdom was formally put on a gold specie standard. The United Kingdom was the first of the great industrial powers to switch from the silver standard to a gold specie standard. Soon to follow was Canada in 1853, Newfoundland in 1865, and the USA and Germany 'de jure' in 1873. The USA used the American Gold Eagle as their unit, and Germany introduced the new gold mark, while Canada adopted a dual system based on both the American Gold Eagle and the British Gold Sovereign. Australia and New Zealand adopted the British gold standard, as did the British West Indies, while Newfoundland was the only British Empire territory to introduce its own gold coin as a standard. Royal Mint branches were established in Sydney, New South Wales, Melbourne, Victoria, and Perth, Western Australia for the purposes of minting gold sovereigns from Australia's rich gold deposits.
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Role Of Gold In Indian Monetary System 1.1.2 The Gold Exchange Standard Towards the end of the nineteenth century some of the remaining silver standard countries began to peg their silver coin units to the gold standards of the United Kingdom or the USA. In 1898, British India pegged the silver rupee to the pound sterling at a fixed rate of 1s 4d, while in 1906, the Straits Settlements adopted a gold exchange standard against the pound sterling with the silver Straits dollar being fixed at 2s 4d. Meanwhile at the turn of the century, the Philippines pegged the silver Peso/dollar to the US dollar at 50 cents. A similar pegging at 50 cents occurred at around the same time with the silver Peso of Mexico and the silver Yen of Japan. When Siam adopted a gold exchange standard in 1908, this left only China and Hong Kong on the silver standard. 1.1.3 The Gold Bullion Standard The gold specie standard ended in the United Kingdom and the rest of the British Empire at the outbreak of the World War I. Treasury notes replaced the circulation of the gold sovereigns and gold half sovereigns. However, legally the gold specie standard was not repealed. The end of the gold standard was successfully effected by appeals to patriotism when somebody would request the Bank of England to redeem their paper money for gold specie. It was only in the year 1925 when Britain returned to the gold standard in conjunction with Australia and South Africa, that the gold specie standard was officially ended. The British act of parliament that introduced the gold bullion standard in 1925 simultaneously repealed the gold specie standard. The new gold bullion standard did not envisage any return to the circulation of gold specie coins. Instead, the law compelled the authorities to sell gold bullion on demand at a fixed price. This gold bullion standard lasted until 1931. In 1931, the United Kingdom was forced to suspend the gold bullion standard due to large outflows of gold across the Atlantic Ocean. Australia and New Zealand had already been forced off the gold standard by the same pressures connected with the Great Depression, and Canada quickly followed suit with the United Kingdom.
1.2 The Bretton Woods System
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. Preparing to rebuild the international economic system as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference. The delegates deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944.
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Role Of Gold In Indian Monetary System Setting up a system of rules, institutions, and procedures to regulate the international monetary system, the planners at Bretton Woods established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement. The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold and the ability of the IMF to bridge temporary imbalances of payments. Then, on August 15, 1971 the United States unilaterally terminated convertibility of the dollar to gold. This action created the situation whereby the United States dollar became the sole backing of currencies and a reserve currency for the member states. In the face of increasing financial strain, the system collapsed in 1971.
1.3 History of the New Monetary System
In 1913, the independent monetary system which the United States had known since its inception was replaced with the Federal Reserve System. Instead of the U.S. Treasury controlling the economy and economic needs, Americans were told that we would be "better off" if we allowed the Federal Reserve handle the economic needs of our country. Our dollars, issued by the United States Treasury, which said "Gold Certificate" or "Silver Certificate" were gradually replaced by ones that said "Federal Reserve Note." Instead of borrowing from the U.S. Treasury for any deficit shortfalls, we borrowed from this independent source, the Federal Reserve. Today, America is beholden to them to the tune of $4.7T. In addition, they control all of the monetary movements in America and the interest paid by taxpayers on the federal deficit is paid to the Federal Reserve, and not the U.S. Treasury. The assault on the purity of the composition of the dollar came on April 20, 1933 when newly-elected President Roosevelt signed the Emergency Banking Act. This legislation made it illegal for "Joe Average American" to own gold and required private citizens to turn in their gold while allowing for the countries of the world holding our currency to convert to gold at any time. With the exception of coin collectors, all American citizens who owned gold or who had Gold Certificates were required to turn their gold in exchange for paper currency issued by the Federal Reserve. In 1944, the United Nations sponsored the UN Monetary and Financial Conference, known as the "Bretton Woods" Monetary Conference as it was held in Bretton Woods, New Hampshire. There 700 delegates from 44 countries met to determine the value of money in the post-World War II era. At this conference, the United States dollar, which had the highest amount of gold reserves backing it, was named the international reserve currency of the world. What this meant was that all of world commerce would use the dollar to trade with and all other currencies would be linked to it at a fixed exchange rate, thus stabilizing the value of world currencies to the value of the dollar. In addition, participating countries could convert their dollars to
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Role Of Gold In Indian Monetary System gold at any time, if they chose to do so. (Currently there is discussion to restructure the agreements made at Bretton Woods by removing the dollar as the world's reserve currency.) From that time, until 1968, when French President Charles deGaulle requested of President Lyndon Johnson that the paper dollars he held be converted to gold, the dollar was premier, as it had plenty of gold backing it, or so everyone thought. It was President deGaulle who very astutely realized that America was monetizing their debt to finance the Vietnam War and he wanted his dollars in gold before the gold window was closed. By the time he converted in June of that year, our gold reserves had dwindled from $30B in 1944 to less than $10.5B. It was, however, President Richard M. Nixon who closed the gold window on August 13, 1971, thus changing the nature of the world monetary system forever and perhaps signaling the "countdown to a world currency." The world's monetary system was transformed from accountability, based on the amount of gold a given country had in its treasury and the amount of paper currency it was printing, to no accountability other than the good opinion of the other countries around the world. This set the stage for the eventual evolution (now currently taking place) of all the world currencies into one. When America went off gold, the rest of the world followed, so that by 1973, with the exception of Switzerland, all of the world was trading in paper. During the time when the shift happened not many countries actively participated in the currency exchange since the trade was limited between few developed countries of those time. Initially only countries countable on a single hand were involved, now the number has grown multifold. Now that the world has seen another monetary crises, just next to the great depression, everyone is willing to shift to a system with a stable currency. This was the topic of discussion in the G-8 summit held in july 09. China’s position was made clear, “To avoid the inherent deficiencies of using sovereign currencies for reserves, there's a need to create an international reserve currency that's delinked from sovereign nations," is the position of the People's Bank of China. The IMF should expand the functions of its unit of account, Special Drawing Rights it feels. The restatement of Governor Zhou Xiaochuan's proposal in March added great weight to the likelihood that China will diversify its currency reserves, the world's largest at $2.0+ now. Zhou Xiaochuan sees the current international financial system as flawed, putting too much emphasis on the $ as a reserve currency. They feel that the $ should depreciate to address the global imbalance. But if this happens and because it’s a reserve currency it would give the rest of the world a monetary crisis too! We are certain China will not wait for the West to accommodate their wishes but as you can see below will act in the short-term to adjust their own reserve policies for the benefit of China. With little cooperation from the West we can now look forward to the destabilization that attends global currency confrontation.
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Role Of Gold In Indian Monetary System China, the biggest foreign holder of U.S. government, is already in the process of cutting its $ holdings. In April it cut them by $4.4 billion to $763.5 billion in April, the first monthly reduction since February 2008 It is difficult for China to do this quickly, for such moves would cause the $ to collapse, if seen as a departure from the U.S. $ by the Chinese. The unhappiness with the $ is not limited to China. Russia holds only Euros in its reserves now, in reaction to the dangers facing the $. Internationally, by the end of 2008 the $ accounted for 64% of global central bank reserves, down from 73% in 2001, after the arrival of the € on the global monetary scene.
1.4 Dollar Problems:
The U.S. $ is being undermined by U.S. economic problems and its over-issuance by the Fed, despite comforting platitudes flowing from U.S. Monetary authorities over the last few years. The threats internal U.S. policies posed to the international monetary system are frightening. The virtually zero response from U.S. monetary authorities to international $ problems, has disturbed eastern central banks because the $ holdings in the reserves of foreigners are huge and could well be diminished in value considerably in the years to come. It is also clear that the U.S. has a great deal to gain both from a depreciating $ and from inflation, despite the impact on the U.S. economy. As a result confidence both in the U.S. economy and in the $ has dropped considerably since the credit crunch impacted in August 2007. The problem is how to get away from the $’s grip without collapsing the global monetary system itself! "The excessive reliance on the credit of several sovereign currencies has added to the risks and crises, the P.B.O.C. said adding, "A currency with stable value in the long term is required."
1.5 Actions Underway for Change
The biggest $ reserve holders are taking small and uncertain steps already:
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Role Of Gold In Indian Monetary System • Russian President Dmitry Medvedev, Chinese President Hu Jintao, Indian Prime Minister Manmohan Singh and Brazilian President Luiz Inacio Lula da Silva called for a "more diversified" monetary system to reduce dependency on the U.S. $ at a June 16th meeting. • In May, China and Brazil began studying a proposal to move away from the $ and use Yuan and Reais to settle trade instead. • Group of 20 leaders on April 2 gave approval for the IMF to raise $250 billion by issuing Special Drawing Rights, or SDRs, the artificial currency that the agency uses to settle accounts among its member nations. It also agreed to put another $500 billion into the IMF's war chest. • This month, Russia and Brazil announced plans to buy $20 billion IMF bonds, while China said it is considering purchasing $50 billion. • IMF First Deputy Managing Director John Lipsky said on June 6th “it's possible to take the "revolutionary" step of making SDRs a reserve currency over time”. The U.S. and other developed nations will attempt to drag out such moves because this disturbs the present global balance of power.
Chapter 2: Review of Literature
2.1 Factors Influencing the price of Gold
Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand, including hoarding and disposal. Unlike most other commodities, the hoarding and disposal plays a much
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Role Of Gold In Indian Monetary System bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price. Given the huge quantity of hoarded gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production. The price of gold is set by the Gold Fixing. Also known as the Gold Fix or London Gold Fixing, this is a meeting of five members of the London Gold Pool that is conducted twice a day by telephone, at 10:30 GMT and 15:00 GMT. Officially, the purpose of the Gold Fixing is to settle contracts between members of the London bullion market. However, the Gold Fixing is widely recognized as the benchmark used to price gold and gold products throughout the world Thought to be one of the first known metals, gold has been coveted throughout history for its beauty, scarcity, malleability, and uncanny resistance to rust and corrosion. Centuries ago, gold’s unique combination of properties – its sun-like color, its soft hardness, and, especially, its imperviousness to decay and corruption – imbued it with magical associations in the eyes of many. Because of these unique properties, gold has traditionally been the currency of choice for much of the world’s population. The value of gold has transcended all national, political, and cultural borders, making it the ideal currency. Historically gold prices were determined by a combination of political and economical factors, till a universally acceptable concept of London and American gold price was institutionalized. An outcome of such initiatives was the Washington Agreement. However, in the past few years, the major factors impacting the gold price can be summarized as under:
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Weak US Dollar Growth in Demand for Jewelry Increase in demand for exchange-traded paper backed products
2.1.1 Weak US Dollar Projections about a declining dollar due to an ever-increasing twin deficit supported by many investment veterans are met by much denial from politicians as well as from investors. As long as foreigners are willing to pour in the amount of $2 billion dollars every working day, the dollar won't crash. But if foreign confidence were to wane, the US dollar will be heading south. No matter how you look at the US twin deficits and America's future fiscal liabilities, this problem is huge and some painful adjustments not only seem to be necessary but unavoidable as well. It should be obvious that one of these major painful adjustments will be a massive devaluation of the US dollar.
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Role Of Gold In Indian Monetary System Simple, the US dollar is the key driver for Gold; as the dollar goes, so will gold; but in the opposite direction. Gold is the anti-dollar with a high inverse correlation to the dollar! In the end, gold is still a monetary asset and trades like a currency. 2.1.2 Growth in Demand for Jewelry In spite of the convergence of Diamond and Palladium, the demand for gold jewelry has seen a regular growth year on year. Countries which are primarily responsible for this growth are India, China, Italy, Turkey and the USA. The demand for consumption of gold in jewelry was 6% higher at 735 tonnes and also comprised a new first-quarter record. The US, which accounts for 10 % of world gold demand, is also one of the markets where public taste in gold jewelry is enjoying a renaissance. The renewed interest in gold also extends to Japan, a market which showed a 19% increase in demand. The Indian market – the world’s largest for gold demand – was 23 % higher following the marriage and festival period which, in turn, has led to restocking by retailers. The earthquake in India, however, is unlikely to hit demand significantly as it occurred in an area which comprises only 5% of the total Indian consumption. There were sharp falls in demand in Turkey and Taiwan - down 38% and 31% respectively. This was due to economic difficulties and continued weakness in investment demand.
2.1.3 Increase in demand for exchange traded paper backed products For the first time in history, gold can be purchased like any listed stock at select stock exchanges of the world like London Stock Exchange, Australian Stock Exchange (Gold Bullion Securities) and New York Stock Exchange (Street Tracks Gold). The World Gold Council initiated Electronic Traded Funds have displayed very good performance and growth in volumes since launch. 2.1.4 Other factors leading to the variation in Gold Prices are: 1) During national crisis, such as a war or a serious natural disaster, the price of gold tends to greatly increase. People start to fear that their paper currency may no longer hold value, but they see gold as a stable asset that can always be used to purchase food and other necessities. 2) Another common factor influencing rising gold prices is the success of the real estate market. When there are low or negative returns on real estate, the demand for gold and other commodities typically is expected to increase. 3) Bank failures, although somewhat uncommon today, can also contribute to an increase in the price of gold. The best example of this occurred during the Great Depression, when rising gold prices due to bank failures led President Roosevelt to ban the holding of gold by private citizens.
2.2
Factors affecting gold prices in last three years
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Role Of Gold In Indian Monetary System If we analyze the track record of gold in the past three years, we can conclude that gold prices have seen a steady and impressive northward growth. In January 2007, gold prices per 10 gm stood at Rs 5,453. By November 2009, the price had gone up to Rs 7,005. The year 2004 has indeed been a great year for gold. There has been a substantial increase in gold prices, but this has not dampened consumers’ inclination towards investments in gold. In fact, investors have begun to recognize the effectiveness of gold as an efficient savings vehicle and an alternate asset class. Globally, the price of gold has historically been impacted primarily by the US dollar. However in the past few years, oil prices, the US dollar and the demand-supply equation for gold have become equally significant contributors to the price of gold.
2.3
Gold as investment
Demand for gold for the purpose of investment has outpaced the demand for the yellow metal for jewelry in 2009. Indians purchased 74.0 tonnes of gold for investment from January to September 2009, while it was 67.8 tonnes during the same period in 2008. While the advantages of having gold in an investor’s portfolio has been talked about time and again, ‘what should be the amount of investment’ is always a question asked by the investors. There are two schools of thought on this subject. The recommendations are in the range of a 15% to 20% allocation of the total portfolio.
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15% of the investment portfolio – European Central Bank decision at the time of establishment in 1999 based on internal studies. 20% of the investment portfolio – Based on a model done by Germmill & Hillman on 20 years data.
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Ideally however, allocation to gold from an investment perspective should be based on comprehensive financial planning. It should always be remembered that investment in physical gold must always be in the form of coins/bars and should be in addition to the jewelry held by the household. Advantages of gold in a portfolio can be explained through the following points:
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Gold has a low to negative correlation with most other asset classes. An investment portfolio with an allocation to gold improves the consistency of portfolio performance during both stable and unstable periods. The price of gold is not linked to the performance of economy, industry or companies. Gold offers the benefit of diversifying portfolio risks.
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Let us consider an example where an investor invests Rs 10,000 each in various options like equities, fixed deposit, PPF and gold in March 1999. Let us see what the returns are in each case, taking the deposit period from 1999 - 2004 into consideration. In gold, by March 2004, his investment would have fetched him Rs
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Role Of Gold In Indian Monetary System 15,063, a substantial increase. The money invested in PPF would have grown to Rs.16,025 by March 2004. A fixed deposit of the same amount would have yielded Rs 13,794 by March 2004. (Refer to the data below for varying interest rates). By March 2004, his investments in equities for the same amount would have become Rs 18,916. This is provided the investor had remained invested in the market throughout the five years, even during periods when the Sensex saw huge downward movements.
2.4
Cost efficient ways of investment in gold internationally
Owning gold has been possible over the years in the form of mutual funds or stocks of gold mining companies. However, investors have been awaiting a more cost effective platform for owning gold. The World Gold council recognized this fact and launched the following ETF gold products across the world. 2.4.1 Gold Bullion Securities For the first time in history, gold was made available at the stock exchange just like an equity share to the investors through a World Gold Council initiated ETF product called Gold Bullion Securities. Each share of Gold Bullion Securities (GBS) is equal to 1/10th of an ounce of gold and is supported by physical holding of gold in the custody of HSBC. This is the first time ever that a metal has been listed on an international Stock Exchange and can be conveniently traded or invested by institutional investors as well as individuals. GBS is listed on the London Stock Exchange and also the Australian Stock Exchange. At present GBS is the most cost efficient way of investing in gold, as a potential investor has to only pay 0.3% p.a. as management fees, which includes the cost of storage and insurance apart from the ‘brokerage’ that they have to pay to the brokers. 2.4.2 Street TRACKS Gold Shares – ETF Gold fund on NYSE The first U.S. exchange-traded fund that tracks the price of gold, called STREET TRACKS Gold Shares, was launched on the New York Stock Exchange in November 2004. This is the first ETF in the U.S. that will track a commodity. It is designed to give investors the opportunity to invest in gold without requiring actual custody of the metal, which can be expensive. The ETF is expected to attract both institutional and individual investors who are looking for a hedge against inflation and currency exchange rates, or for diversification. It is sponsored by the World Gold Council and marketed by ETF provider State Street Global Markets. Each share will represent one-tenth of an ounce of gold bullion as priced by the London Bullion Market Association. The 2.3 million shares trade under the ticker symbol "GLD."
2.5 Indian Foreign Exchange Reserves
India’s accumulation of foreign exchange reserves has been unprecedented scale in recent years. Given the cost of holding huge foreign exchange reserves, the cost of holding these reserves is also on the increase. The source of accretion to the foreign exchange reserves is mainly the capital flows and is portfolio flows
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Role Of Gold In Indian Monetary System more recently. Hence, given the cost and the volatility of the capital flows which is the main source of accretion, India needs to decide on the composition of its foreign exchange reserves. Central banks of many of the countries are considering the re-engineering of their foreign reserves. The share of gold in the total foreign exchange reserves is very high in the US and in the Europe. But, the Asian economies hold a very low proportion of their foreign exchange reserves in gold. This section analyses the trends in the accumulation and sources of accretion of Indian foreign exchange reserves from the view point of if India should increase its gold holdings. Shri. S. S. Tarapore, a former Deputy Governor of the Reserve Bank of India (RBI) and Chairman of the Committee on Fuller Capital Account Convertibility, has suggested that India should increase the share of gold in its foreign exchange reserves. He said, “Gold is unique, in the sense that it is both a commodity and a store of value. More importantly, gold invariably moves inversely with the US dollar and also rises in value when international inflation gathers momentum“ In the aftermath of Asian crisis, the Emerging Market Economies (EMEs) have started accumulating foreign exchange reserves on an unprecedented scale. As reported by the Bank for International Settlements (BIS), the EMEs have accumulated reserves at an annual rate of US $250 billion (or 3.5% of their annual combined GDP) during 2000 and 2005. This is almost five times higher than the level that was prevalent in the early 1990s. (Mohanty and Turner 2006) The accumulation, as ratio to GDP, is particularly rapid in China, Korea, India, Malaysia, Russia and Taiwan (China). The accumulation of foreign exchange reserves by the EMEs is to insure against the risks of capital volatility and to protect the monetary system from shocks like the speculative attacks by the currency traders. High foreign exchange reserves are often seen as a strength indicating the backing that a currency has. To some extent, the holding of huge foreign exchange reserves also indicates the lack of confidence on the global financial architecture. With the high foreign exchange reserves accumulation, concern mounts on the costs and benefits of holding it. Hence, the composition of assets in which these foreign exchange reserves are invested, the risks they represent, the return they yield and the risk-return trade off involved become important issues. If the reserves are held as an insurance against financial crisis, then the assets need to be highly liquid and most safe. The emphasis will not be as much on earning a high yield. But, if the reserves are far greater than what is required for withstanding financial crisis, the choice of assets for investment of these reserves will be guided by return maximization as the costs of holding huge foreign exchange reserves is also high. 2.5.1 Official Stock of Gold During the gold standard the central banks started accumulating gold. In 1870, Bank of England had a gold reserve of 161 tonnes. It rose to 248 tonnes in 1938. But, the gold holding of the other countries were even higher. US had 2293 tonnes, Russia 1233 tonnes, France 1030 tonnes, Argentina 440 tonnes, Germany 439 tonnes, Austria 378 tonnes and Italy 355 tonnes. Australia had 309 tonnes. The world’s total official gold
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Role Of Gold In Indian Monetary System reserves were estimated to be around 8000 tonnes in 1913 well above the 700 tonnes in 1870. US official gold holdings increased from 6000 tonnes in 1925 to 18000 tonnes at the end of World War II. This was about 65% of all the official stocks of gold. In the 1960s, the official gold stock was about 38000 tonnes. This was around 50% of all above ground stocks. Even during the Bretton Woods system, central banks held gold reserves because the official dollar price was fixed in gold. Gold was still at the core of the international monetary system as dollar was freely convertible into gold. But, after the Jamaica agreement IMF sold half of its gold holdings to help the poor nations and returned the other half to the members. Many countries also reduced their stock of gold. In 1978 the articles of IMF was altered forbidding the countries from pegging their currencies against gold. The stock of gold in foreign exchange reserves, as a result, has changed radically over the past three decades. Gold holdings valued at market prices fell from about 60% in 1980 to as low as 9% in 2005. (Woolridge, 2006) The policy on management of gold reserves has also undergone a change over time. Initially, the gold reserves were segregated from other reserves assets and the physical holdings of gold were left unchanged even if prices fluctuated. Since the 1970s, reserve managers gradually diversified into higher yielding and higher risk instruments. Hence, holding of gold in high proportion was considered inefficient when viewed from current yield perspective. Gold does not earn any interest other than the return that it fetches if lent. That is why many central banks decided to reduce their gold holdings. Foreign currency assets started replacing gold as the main reserve asset. According to WGC, central banks held around 18% of the above ground stocks of gold as a reserve asset in 2005. This figure has been decreasing over time. In recent years, all the newly mined gold is being absorbed by the jewellery fabrication, industries and private investment. The official sector is a net supplier of gold rather than the buyer. Between 2001 and 2005, the central banks had contributed an average of 562 tonnes to annual supply flows.
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Role Of Gold In Indian Monetary System
Source: World Gold Council athttp://www.gold.org/value/reserve_asset/gold_as/reserve_stats.html 2.5.2 Gold as a Reserve Asset The International Monetary Fund’s (IMF) Balance of Payments Manual contains the following definition of foreign exchange reserves: “Reserve assets consist of those external assets that are readily available to and controlled by monetary authorities for direct financing of payments imbalances, for indirectly regulating the magnitude of such imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for other purposes.” Archer and Halliday (1998), Nugee (2000), Williams (2003) and IMF (2004) discuss the purpose of maintaining reserves. The purposes of maintaining foreign exchange reserves
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Role Of Gold In Indian Monetary System may be viewed from (i) monetary policy perspective and (ii) financial stability perspective. (i) Monetary policy perspective: For a country that follows a fixed exchange rate regime, foreign exchange reserve has an important function. In order to keep the currency exchange rate fixed, the central bank of the country has to trade in the currency market to balance the demand and supply. This requires foreign exchange reserves. However, the need for maintaining foreign exchange by a country that follows a floating exchange rate is questioned. But, such a country also requires foreign exchange to intervene in the market if a misalignment between the real exchange rate and market rate occurs. Besides, the central bank may also feel compelled to intervene in the foreign exchange market to counter inflation that may be caused by rising import prices due to depreciation in the domestic currency. The rating agencies consider that the quantum of foreign exchange reserves kept by a country enhances the credibility of its monetary policy. Hence, a country wanting to get a good rating should keep sufficient reserves. (ii) Financial stability perspective: Reserves act as shock absorbers and soften the impact of shocks like unexpected fluctuations in the currency account, changes in access to foreign markets or natural catastrophes. The reserves could ensure a balanced currency inflows and outflows under unexpected circumstances. In general, foreign exchange reserves will ensure that the forex market is functional and in the event of any market failure, the central bank can intervene. If the foreign exchange reserve maintained by a country is considered not adequate, the investors may get speculative on the currency and affect its pricing. If the reserves are adequate the confidence in the currency will get boosted and the currency will not come under such a speculative attack by the investors. Holding of adequate foreign exchange reserves by a country ensures that sufficient funds are available to service the treasury’s foreign liabilities. Y.V. Reddy (2006) summarizes the benefits of holding foreign exchange reserves, which also the purposes for holding them: “In any country risk analysis by rating agencies and other institutions, the level of reserves generally has high weights. Moreover, it is essential to keep in view some hidden benefits which could accrue to a country holding reserves, which may, inter alia, include: maintaining confidence in monetary and exchange rate policies; enhancing the capacity to intervene in foreign exchange markets; limiting external vulnerability so as to absorb shocks during times of crisis; providing confidence to the markets that external obligations can always be met; and reducing volatility in foreign exchange markets.” (pp.2). Gold can serve all these purposes. Gold is a unique asset in the sense that it is liability to none. Gold is not a subject to any country’s economic policy. Hence, it stays unaffected by the monetary and fiscal policies of any country. World Gold Council (2001) argues that the monetary problems of the modern economy would see resurgence in the importance of gold. It can hedge the risk of inflation. Aggarwal (1992) shows that gold may be an inflation hedge in the long run but it is also characterized by significant short run price volatility. Ghosh and others (2002) prove using monthly gold price data and co-integration regression techniques that gold can be regarded as a long run inflation hedge. Mani and Vuyyuri (2004) have shown that the prices of
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Role Of Gold In Indian Monetary System gold and inflation have moved in the opposite direction from 1978-79 to 1986-87. Subsequent to this, till 1991-92 the prices have moved parallel to each other. Inflation started to fall after 1991-92, but the price of gold moved up. Between 1978-79 and 1999-2000, the prices of gold have shown an upward trend. The correlation between inflation and gold prices was -0.13658. Hence, gold can act as a store of value. Gold is highly liquid and can mobilize the necessary funds in case of emergencies. To meet the balance of payments crisis on account of oil price rise, Italy pledged gold with Bundesbank and secured a $2 billion loan. Romania also used gold as collateral to secure a loan to repay external debt in 1974. In 1991 India had to tackle a balance of payment crisis. It sold 20 tonnes of gold in Swiss market and offered 46 tonnes of gold to Bank of Japan as collateral. Russia, when encountered with financial crisis in 1998 sold off 33% of its gold reserves. In 2001, the country sold its gold holdings once again to generate funds to tackle the series of natural disasters that had befallen on the country. In the aftermath of 1997 Asian financial crisis, Malaysia, South Korea and Thailand appealed to their residents to lend their gold against local government bonds to facilitate the countries to reduce their debt. This helped to stabilize their currencies. Alan Greenspan said in 1999, “…. gold still represents the ultimate form of payment in the world. It’s interesting that Germany could buy materials during the war only with gold. In extremis fiat money is accepted by nobody and gold is always accepted and is the ultimate means of payment and is perceived to be an element of stability in the currency and is the ultimate value of the currency. And that historically has always been why governments hold gold.” (Remarks by Alan Greenspan to US Congress in 1999) 2.5.3 India’s reserves’ position and movement since Independence The Reserve Bank of India (RBI) is the custodian and the manager of foreign exchange reserves of the country. This is provided for in the Reserve Bank of India Act, 1934. The preamble of the act defines the objective of the reserve management in India as, “…. keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.” Accretion to foreign exchange reserves arise out of purchases by the RBI from Authorized Dealers and from the income on foreign exchange assets deployed. Government aid receipts also add to the foreign exchange reserves. Although both US dollar and Euro are the intervention currencies, the foreign exchange reserves are denominated and expressed only in the US dollar. India’s foreign exchange reserves have been steadily increasing since 1991. The foreign exchange reserves were US $5.8 billion as at the end of March 1991. Reserves increased to US $ 25.2 billion by March 1995. At the time of Asian financial crisis in December 1997 it was US $27.355 billion. It further rose to US $38.0 billion by March 2000. The foreign exchange reserves at the end of every year from March 2003 to March 2005 were US $76.1 billion, US $113.0 billion and US $141.5 billion respectively. The figure as at the end of March 2006 stood at US $151.6 billion. The chart below illustrates the growth of foreign exchange reserves of this country from 1991 to 2006. It can be
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Role Of Gold In Indian Monetary System seen from the chart that Indian foreign exchange reserves have been registering a steady growth and it is more rapid in the recent years. It should be noted here that the foreign exchange reserves data prior to 200203 do not include the Reserve Tranche Position in IMF.
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2.5.4 India’s Accumulation of Foreign Exchange Reserves India was a closed economy till 1991. The opening up of Indian economy happened in the wake of a balance of payments crisis it encountered in 1991. Current account was in surplus for most years until 1980. India’s economic policies were emphasizing import substitution rather than export led growth. But, from the beginning of 1980s the current account started showing a deficit. During the first half of the 1980s, the current account deficit stayed well below 2% of GDP. In the second half of 1980s, current account deficit widened because of oil price hike. Prior to
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Role Of Gold In Indian Monetary System 1991, capital flows to India predominantly consisted of aid flows, commercial borrowings and non-resident Indian deposits. (Chopra and others 1995) India’s external debt was at US $69 billion by the end of 1990-91. Medium and long-term commercial debt stood at US $10.5 billion. Short-term external debt grew sharply to US $6 billion. The ratio of debt-service payments to current receipts was as big as 30%. India’s balance of payments also suffered from capital account problems due to erosion of investor confidence. India’s foreign exchange reserves were US $ 5.8 billion at the end of March 1991. It further depleted to US $975 million on July 12, 1991. It was barely enough to pay for a week’s imports. The country had to sell 20 tonnes of gold in Swiss market to raise finance. It shipped another 46 tonnes of gold to London to offer as collateral for a loan of about US $415 million from Bank of Japan, as a adhoc measure before a loan could be arranged with International Monetary Fund (IMF). This forced the country to initiate liberalization of economic policies that led to opening up of the domestic markets to international investors. Its current account was opened up only in August 1994. The capital account is being gradually liberalized. As a result, the foreign exchange reserves which stood at US $5.8 billion as at the end of March 1991 registered a phenomenal increase. It was at US $151.6 billion at the end of March 2006. 2.5.5 Sources of Accretion to Foreign Exchange Reserves The main source of accretion to foreign exchange reserves during the period 1991-92 to 2005-06 is the capital account surplus. The increase in foreign exchange reserves is caused by an increase in the annual quantum of foreign direct investment from US $129 million in 1991-92 to US $57.7 billion in 2004-05 and future to US $7.2 billion in 2005- 06. The outstanding NRI deposits grew from US $13.7 billion at the end of March 1991 to US $35.2 billion at the end of March 2006. Foreign Institutional Investors (FIIs) are allowed to make portfolio investments in India since 1993. The cumulative FIIs investments increased substantially from US $827 million in December 1993 to US $45.3 billion in March 2006. India’s exports, which stood at US $17.9 billion in 1991-92, rose to US $100.7 billion in 2005-06. Net invisible inflows grew from US $1.6 billion to US $40.9 billion in 2005-06. India’s current account was in deficit at 3.1% of GDP in 1990- 91. It turned into a surplus of 0.7% in 2002-03. A surplus in the invisibles account helped to post a surplus in the current account to the tune of US $14.1 billion in 2003-04. However, this could not be sustained. In 2004-04, the current account registered a deficit of US $5.4 billion. The deficit continued in 2005-06 and was at US $10.6 billion. 2.5.6 Components of Indian Foreign Exchange Reserves The three components of the foreign exchange reserves of India are Gold, Special Drawing Rights (SDRs), and Foreign Currency assets (FCAs). The RBI Act permits investment of foreign exchange reserves only in the following categories: (i) Deposits with other central banks and the Bank for International Settlements. (BIS). (ii) Deposits with foreign commercial banks.
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Role Of Gold In Indian Monetary System (iii) Debt instruments representing sovereign/sovereign-guaranteed liability with residual maturity not exceeding 10 years. Other instruments/institutions as approved by the Central Board of Directors of the central bank. The following table gives the investment of Indian foreign exchange reserves. It can be noticed from the table that the country has increased its investment in foreign currency assets over time with the increases in the level of foreign exchange assets. This is very much in line with the global trend. From the 1970s, monetary authorities have gradually shifted out of gold. They started reallocating their reserves to foreign currency assets that offer more attractive risk adjusted returns. Bank deposits have gained importance in recent years. Wooldridge (2006) says, “Monetary authorities have since the 1970s gradually diversified into higher-yielding, high-risk instruments. Nevertheless, official reserves are still invested mostly in very liquid assets, with limited credit risk. After falling markedly, the proportion invested in bank deposits has increased slightly in recent years. This is mainly because of the rapid accumulation of reserves by developing countries, which tend to place a larger share of their reserves with banks than do industrial countries”. (pp.31) As at the end of March 2006, of the US $145108 million invested in the foreign currency assets, US $109936 was kept as deposits with other central banks, BIS and foreign commercial banks. This was the case in March 2005 as well. Of the US $135571 million invested in foreign currency assets, US $98752 million were held as deposits. The increase in the value of gold holdings is because of the increase in the global prices of gold rather than from fresh investment. The table of India’s foreign exchange reserves gives the physical holding of gold. It can be seen that the physical holding of gold has not changed at all over March 2000 to March 2006. But, the share of gold in the foreign exchange reserves as come down as US $ 112928 millions were added to the reserves during this period. As at the end of 1990 India had 333 tonnes of gold. It increased to 398 tonnes at the end of 1995 partially due to the acquisition of confiscated gold. The physical holding of gold reduced by about 39 tonnes and the stock stood at 358 tonnes in 1998. This is due to the repayment on maturity of gold backed bonds issued in 1993. Since then the stock of gold has remained unaltered.
2.6 Gold Market Report by Data Monitor
2.6.1 Research Highlights The global gold market generated total revenues of $67.2 billion in 2008, representing a compound annual growth rate (CAGR) of 20.3% for the period spanning 2004-2008. Market production volumes experienced fluctuations in growth between 2004-2008, posting both negative and positive growth rates and declining slightly overall from its 2004 level, to reach a total of 2,434.6 metric tonnes in 2008. The performance of the
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Role Of Gold In Indian Monetary System market is forecast to decelerate, with an anticipated CAGR of 2.3% for the five-year period 2008-2013, which is expected to drive the market to a value of $75.2 billion by the end of 2013. 2.6.2 Market Analysis The global gold market has posted strong, double-digit growth rates over 2004-2008 period. The market is forecast to grow in value towards 2012; however at a significantly lower rate. The global gold market generated total revenues of $67.2 billion in 2008, representing a compound annual growth rate (CAGR) of 20.3% for the period spanning 2004-2008. In comparison, the European and Asia-Pacific markets reached respective values of $8 billion and $21 billion in 2008. Market production volumes experienced fluctuations in growth between 2004-2008, posting both negative and positive growth rates and declining slightly overall from its 2004 level, to reach a total of 2,434.6 metric tonnes in 2008. The market's volume is expected to rise slightly to 2,436.9 metric tonnes by the end of 2013, representing a CAGR of less than 0.1% for the 2008-2013 period. The performance of the market is forecast to decelerate, with an anticipated CAGR of 2.3% for the five-year period 2008-2013, which is expected to drive the market to a value of $75.2 billion by the end of 2013. FIGURE 1: Global Gold Market Value
2.6.3 Portfolio diversification Asset allocation is an important aspect of any investment strategy. By balancing asset classes of different correlations, investors hope to maximize returns and minimize risk. However, while many investors may believe that their portfolios are adequately diversified, they typically contain only three asset classes stocks, bonds and cash.
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Role Of Gold In Indian Monetary System To counter adverse movements in a particular asset or asset class, many investors now strive to achieve more effective diversification in their portfolios by incorporating alternative investments such as commodities. While gold has shown strong returns over recent years, its most valuable contribution to a portfolio lies in the fact that it is not correlated with most other assets, as shown in the chart below. This is because the gold price is not driven by the same factors that drive the performance of other assets. FIGURE 2: 5-Year Correlation of Weekly returns
The sources of demand for gold are far more diverse - both geographically and sectorally - than those for many other assets, which helps to explain the independence of the gold price as well as why identifiable demand has remained robust in the face of a rally that has spanned several years. The value of gold demand increased by 219% between 2001 and 2008. Moreover, most spending on gold is discretionary. 68% of total identifiable demand over the five years to December 2008 came from the jewellery sector, with a further 20% from investment and 12% from industrial demand. This is unusual for commodities, where demand is typically driven by non-discretionary spending and is consequently more exposed to the vagaries of the economic cycle. The recent growth in investment demand, at both the institutional and retail level, with a 141% increase in tonnage demand over the last five years (to year-end 2008), has further broadened the demand base for gold, and this can act as a counterbalance when recessionary pressures may dampen consumer demand for jewellery. Gold offers enhanced diversification opportunities relative to many alternative assets. Independent studies have shown that while alternative assets and traditional diversifiers often fail during times of market stress or instability, even a small allocation to gold may significantly improve the consistency of portfolio performance during both stable and unstable financial periods.
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Role Of Gold In Indian Monetary System 2.6.4 Gold and the dollar Gold has long been regarded by investors as a good protection against depreciation in a currency's value, both internally (i.e. against inflation) and externally (against other currencies). In the latter case, gold is widely considered to be a particularly effective hedge against fluctuations in the US dollar, the world's main trading currency. FIGURE 3: Gold and the trade-weighted Dollar
2.6.5 Consumption and Production of gold across countries Globally, gold production and consumption predominantly occurs in countries whose currencies are not tied to the US dollar. Price changes when measured in the currencies of these gold producing and consuming countries, and deflated by local inflation, provide an important indication of the price factors underlying trends in gold production and consumption. As an exercise to highlight these price developments, since 1999 GFMS has published in the annual Gold Survey production and consumption weighted price indices. The production weighted price index is based on gold prices, measured in domestic currencies, for the Top 10 gold producing countries in 2001 (these countries account for around 75% of annual world mine production). Individual country indices of the gold price, expressed in each country’s national currency, and deflated by that country’s CPI (Consumer Price Inflation) are constructed. A weighted aggregate index is then calculated from these indices. The weights are obtained by taking each country’s share in the Top 10’s mine production for each year. For 2001, these weights are as follows:
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Role Of Gold In Indian Monetary System TABLE 3: Gold Production weighted index of countries
Source: GFMS (Gold Field Mineral Services)
The consumption weighted price index is constructed is a similar manner. This index utilizes data from the Top 19 jewellery consuming countries in 2001, which account for around 75% of annual global jewellery demand. The countries and associated weights in 2001 are shown below. TABLE 4: Gold Consumption weighted index of countries
Source: GFMS (Gold Field Mineral Services)
The Figure overleaf illustrates the evolution of the production and consumption weighted price indices from January 1994, alongside the US dollar gold price index (deflated by US CPI). Between 1994 and 1997, all three indices move in a broadly similar manner, indicating that exchange rates and inflation in the United States and producing and consuming countries followed comparable trends. However from 1998 the production index begins to diverge, rising strongly above both the US dollar and consumption weighted indices, and illustrating weakening real exchange rates in key producing countries. Moreover from January 2000, the consumption index also moves above the US dollar index, again showing a real strengthening of the dollar.
FIGURE 4: Production and Consumption Weighted Real Gold Price
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Source: GFMS (GOLD FIELD MINERAL SERVICES)
Over the period 1994-2001, global mine production increased by 14%, with rises in Indonesia, Peru and China (amongst others) outweighing a large (33%) fall in production from South Africa. Rather paradoxically, South Africa experienced the largest rise in the real domestic price whilst recording the greatest drop in production. This reflects the mature nature of the South African gold mining industry lower grades, an aging infrastructure and industry consolidation have all contributed to the decline in South African mine production. That this occurred against the background of a 39% increase in the real domestic gold price begs the question: what would production have done had local prices followed the 33% fall in the real US dollar price? Undoubtedly, the decline in production would have been more marked as industry consolidation would have accelerated and marginal shaft sections closed earlier. The situation in Canada, which experienced a 17% fall in the real local price against the 33% fall in the US dollar price, is similar to that of South Africa. Canadian mine production has been more robust than that of South Africa, increasing by 8% between 1994 and 2001. However, in recent years, small mines have been closing and production has fallen by 8% since 1997. Undoubtedly, the pace of these closures would have been greater had local prices fallen as much as the US dollar price. By contrast, GFMS estimate that production in Peru and Indonesia, which experienced a 22% fall and 7% rise in the domestic prices respectively, is less sensitive to price developments. Developments in Peru have been linked to mining laws encouraging foreign investment, whilst Indonesian production is dominated by production at Grasberg, where gold output is a by-product of copper production. Australia experienced an 11% increase in mine production between 1994 and 2001, although since 1998 production has been on a downward trend. Real local prices fell by 16% over the January 1994-June 2002
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Role Of Gold In Indian Monetary System period, but have increased by 15% since 1998. GFMS believe that the recent fall in Australian mine production is less related to domestic price developments than ore depletion at a number of historically important operations. Turning to consumption, the story is equally divergent. Jewellery consumption between 1994 and 2001 increased by 14%. Major changes occurred in India and the Middle East on the positive side, and China on the negative side. Indian jewellery consumption increased by 289 tonnes (89%) whilst combined consumption in the UAE, Saudi Arabia, Iran and Egypt rose by 138 tonnes (51%). These are the typical price sensitive regions. Indian real prices actually declined by 37% between 1994 and 2001 (against the 33% fall in the dollar price) suggesting that domestic inflation (leading to a strengthening of the rupee in real terms) may have bolstered demand, whilst in the Middle East, with the exception on Iran, real prices fell by less than the dollar price, a factor that may have tempered offtake. The situation in China is an interesting case, although real prices fell by 41%, consumption dropped by close to 40%. This reflects the fact that the Chinese market has been experiencing a secular downward trend. Although the sensitivity of both global demand and supply to changes in local prices is difficult to gauge, weakness in producer currencies over the last six years has undoubtedly acted to boost supply above the level that would have occurred with stable real exchange rates. The situation for demand may be less clearcut largely as weakness in consuming countries’ currencies has been less pronounced. The extension of these arguments is that in the absence of real weakness in producer currencies, global mine supply between 1995 and 2001 would have been lower, and US dollar prices therefore probably higher. 2.6.6 Consumption of gold across BRIC nations: India is by far the largest buyer of gold among the BRICs, now accounting for 15% of total world demand. But India’s consumption is actually below its peak in 2001—in both volume and percentage terms despite expectations that the economic boom there would spark higher consumption. This may reflect financial liberalization, which is undermining one of the traditional drivers of Indian gold consumption.
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2.7 Future of gold investments in India:
Despite the global slowdown, weaker dollar value and reduced physical offtake, total consumption of gold in India may remain static to around 800-850 tonnes for the calendar year 2009, from 900 tonnes last year, thanks to sustained rural buying and retail investment demand, trade sources said. Traders expect total imports of gold to remain around 475-500 tonnes during the year. In 2008, the country imported total 712.6 tonnes of gold, according to World Gold Council (WGC). Of which, 500 tonnes of gold was for Jewellery making and 211 tonnes for investment purposes. In 2009, the country may import less gold but the consumption for gold jewellery and investment purposes would remain steady, Agri-commodity Consultant, Dhimant Bhatt said. “I believe total imports would reach to round 500 tonnes this calendar year though higher prices have gone up to record levels recently. Standard gold prices in the domestic market hovered around Rs16,800 per 10 gram, an all time high levels,” Bullion Analyst, Bhargav Vaidya said. Average price of gold in 2009 so far has increased by 21% to Rs15,105 per 10 gram from average Rs12,500 per 10 gram in the full year 2008. “The gold market become more vibrant and I would like to add that price gap between landing cost of imported gold and market price has reduced to almost zero levels and there is no disparity in the market due to availability of online spot trading platform for gold trading,” RiddiSiddhi Bullions managing director, Prithviraj Kothari said. It can be noted that gold prices jumped up by nearly 1.5 times from average Rs5,850 in 2004 to Rs15,105 per 10 gram over past five years on increasing demand for investment purpose. It is considered as a hedge against inflation. COMEX gold futures for December delivery traded near $1,120 an ounce last week after rallying to a fresh record of $1,122.20 an ounce in the previous session. A weak US dollar and general flat currency fear across the globe shot up the gold price to new highs.
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2.8 Gold and the international monetary system – a chronology
1717 In UK Sir Isaac Newton (Master of the Mint) gives guinea statutory valuation of 21sh (shillings). Mint price of gold 77sh 10½d per standard ounce. UK Gold Standard commences. Napoleonic Wars. Bank of England suspends gold payments. UK Coinage Act (Post-Napoleonic Wars). Sovereign the standard unit @ one standard ounce of gold (>11/12 fine) = 77sh 10½d. Bank of England obliged to buy gold @ 77sh 9d. All major countries, other than China, switch to the gold standard, linking their currencies to gold. Bimetallism is abandoned. Federal Reserve Act establishes US system of reserve banks. At least 40% of note issue to be backed by gold. US prohibits gold exports. UK prohibits gold exports without official permission. UK now off Gold Standard. US gold exports permitted again. London Gold Fixing established. 1925 UK returns to Gold Standard at pre-War parity of $4.86=£1 UK Gold Standard Act. Currency convertible @ 77sh 10½d per standard ounce. But only in amounts of 400 oz. Export of gold again permitted. 1931 1933 UK abandons Gold Standard. US convertibility suspended (with gold @ $20.67/oz). Export, all transactions and holding of gold forbidden. Presidential Proclamation makes dollar again convertible to gold (at new price of $35/oz) Tripartite Agreement. US, UK and France willing to buy and sell gold freely with each other in exchange for own currency. London gold market closed on outbreak of war. Bretton Woods Conference sets basis of post-war monetary system. US dollar to maintain $35=1 oz gold conversion rate. Other currencies to be fixed (but adjustable) in terms of US dollar, thus forming a Gold Exchange Standard.
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1797 1816
1844 18701900 1913
1917 1919
1934 1936
1939 1944
Role Of Gold In Indian Monetary System 1945 IMF Articles of Agreement effective. Par values established for all members based on gold value of US dollar on 1 July 1944 (0.888671 grammes of fine gold). London gold market re-opens after World War 2. Gold Pool established (members Belgium, France, Germany, Italy, Netherlands, Switzerland, UK and Federal Reserve Bank of New York: France withdrew in June 1967). Members would sell (and later buy) gold in the London market to maintain prices close to par in that market. Sterling devalued from $2.80 to $2.40. This leads to pressure on the dollar and hence to substantial buying of gold. London market closed at request of US government. Gold Pool abolished and 2-tier market created. Central banks transact only among themselves at official price and neither buy nor sell from London or any other market. Private sector, however, free to do what it likes, with floating gold price. London market re-opens 1 April and now fixing in US$ for first time. First amendment to IMF articles agreed. A new reserve asset, the Special Drawing Right (SDR) was created and given the value of 0.888571 gram of fine gold, the same value as the US dollar in July 1944. 1971 US$ convertibility to gold suspended. Smithsonian Agreement on new exchange rates. 1972 1973 US$ devalues to $38/fine oz. US proposes further devaluation to $42.22/fine oz. Major central banks suspend dealing in foreign exchange markets. Most major countries adopt floating exchange rate regime. US devaluation effective. 2-tier gold market formally abandoned. 1975 US abolishes restrictions on citizens buying, selling or owning gold (formerly needed Treasury licence). First US gold auction (2 million oz auctioned; less than half bid for). Second US gold auction (½ million oz).
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1954 1961
1967
1968
Role Of Gold In Indian Monetary System Group of 10 major industrial countries and Switzerland agree that there would be no attempt to peg price of gold and that total stock held by the IMF and the monetary authorities of the G10 countries would not be increased. IMF’s Interim Committee agrees to disposal of 50 mn oz (one third) of Fund’s gold. 25 mn oz to be sold and surplus devoted to a Trust Fund which would extend concessional loans to lowincome members and the other 25 mn oz to be restituted to members at the official price. 1976 1978 First IMF gold auction. 2nd Amendment to IMF Articles of Agreement comes into effect. Gold’s formal role in international monetary system disappears. US gold auctions resume. 1979 European Monetary System established. Those participating in its exchange rate arrangements must - and other members can - swap 20% of gold and US$ reserves on rolling quarterly basis with European Monetary Cooperation Fund for ECU Final US gold auction. During the two phases (1975; 1978/79) some 530 tonnes (17 mn oz) were sold. 1980 Last of 45 IMF gold auctions. 25 mn oz (= 778 tonnes) were sold in all at average price of $240 (lowest/highest prices $109/$712). US Gold Commission reports to Congress. Official holdings of 264 mn oz should certainly not be reduced to zero and a minority favoured no reduction at all. Plaza Agreement on currencies. Louvre Accord on currencies. Treaty on European Union signed at Maastricht. This includes agreement for qualifying countries to proceed to Economic and Monetary Union (EMU - the single currency) on a default date of January 1999. Provision is made for the mutation of national central banks into the European System of Central Banks (ESCB) headed by the European Central Bank (ECB). The ECB will be able to call an initial amount of Ecu50bn (Euro 50bn) of gold and foreign reserve assets from participating countries. Reserve management of all ECSB banks, including that of gold holdings, will be subject to guidelines to be issued by the ECB council. Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain confirmed as participants in EMU, scheduled to start in January 1999. The Governing Council of the European Central Bank decides that 15% of its initial reserves of 39.5bn Euro, due to be transferred to it on the first day of 1999, will consist of gold. The Council also agrees that before the end of the year it will adopt an ECB guideline which will subject all
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1982
1985 1987 1992
1998
1998
Role Of Gold In Indian Monetary System operations in foreign reserve assets remaining with the national central banks, including gold, to approval by the ECB. 1998 The swaps of 20% of their gold and US$ reserves deposited with the European Monetary Institute (formerly the European Monetary Cooperation Fund) by EU national central banks in return for Ecu are unwound. European Monetary Union starts. The eleven founding members transfer a total of 39.6bn euro of gold and foreign exchange reserves to the European Central Bank. 15% of this is gold. Central Bank Gold Agreement (CBGA) announced. Under this 15 European central banks (the European Central Bank, the eleven members of European Monetary Union, Sweden, Switzerland and the UK) declare that gold will remain an important element of global monetary reserves, that they will collectively cap their gold sales at around 400 tonnes per year over the next five years and that they will not expand their gold leasings and their use of gold futures and options over this period. See the section on Central bank agreements on Gold for more details. Second Central Bank Gold Agreement announced. The CBGA was renewed for a further five years from September 27 2004 to September 26 1999 with an annual limit to sales of 500 tonnes. See Central bank agreements on Gold for further details and its differences from the first Agreement.
1999
1999
2004
Chapter 3: Research Methodology
To understand the role played by gold in the new Indian monetary system, it is very important to first understand what the monetary system is and its evolution as a system over the past few decades. Gold has
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Role Of Gold In Indian Monetary System been around for centuries and has always been a vital part of not only Indian monetary system but also the Global monetary system. Gold's effect on the monetary system is multi-pronged and can be studied in details when the roles are sub-divided into smaller, well-defined roles. This research tries to analyse in this manner. After conducting an exploratory research through a series of Focus Group Discussions and Depth Interviews and also with the help of secondary data available, the primary objective of the research has been branched into five secondary objectives wherein the fulfillment of these secondary objectives will in its place will fulfill the primary objective of the research.
3.1 Research Objective
3.1.1 Primary Research Objective (PRO) The objective of this research report is to present its readers the role of gold in the new Indian monetary system. 3.1.2 Secondary Research Objectives (SRO) ? To determine the significance of gold as a tool in the global market system.
? To determine the contribution of Gold in India’s exchange reserves. ? To determine the major factors influencing the price of Gold. ? To determine the significance of Gold as an investment as compared to other investment
opportunities.
? To determine the consumption pattern of Gold in India.
3.2 Tools Used
1) Daily newspapers to keep track of new developments 2) Magazines and journals to gain a deeper understanding of specific topics with relation to Gold and opinion of experts who are in a similar domain 3) Online websites to access different information and access other similar research work, if any 4) Interview with faculties from finance to understand their perspective and insights related to Gold.
3.3 Sample
We developed a questionnaire (see the annexure) based on which, questions were asked to the working professionals & faculty of SCMHRD. The questions were abstract and indirect in nature and mode of communication was primarily a face-to face interview. 50 responses were filled to analyze the importance of Gold as investment.
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Role Of Gold In Indian Monetary System
3.4 Research Methodology:
Data was analyzed using cross tabs & Chi-Square in SPSS software. Table 5: Salary v/s Gold Deposits
Crosstab Count golddeposits .00 salary less than 120000 between 120000 to 250000 Between 250000 to 500000 between 500000 to 1000000 more than 1000000 Total 9 6 4 2 2 23 1.00 1 4 6 8 8 27 Total 10 10 10 10 10 50
TABLE 6: Chi-Square Tests
Chi-Square Tests Asymp. Sig. (2Value Pearson Chi-Square Likelihood Ratio Linear-by-Linear Association N of Valid Cases a. 14.171a 15.556 12.783 50 df 4 4 1 sided) .007 .004 .000
5 cells (50.0%) have expected count less than 5. The minimum expected count is 4.60.
FIGURE 6: Bar Chart- Gold Deposits of different Income Levels
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Role Of Gold In Indian Monetary System
Findings:
The p-value is 0.007. With 90 percent confidence level, we can say that as salary increases, the investment in Gold increases.
Figure 7:Forms of investment in Gold
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Role Of Gold In Indian Monetary System Conclusion: Though the world is moving towards development, new avenues of investment in gold like Gold ETFs have been introduced. But still in India, people wish to invest in Gold in the form of jewellery. The main reason of it is the lack of awareness & knowledge about Gold ETFs. Ease of investing in jewellery also makes it a preferable option. In Gold ETFs, gold is traded in the form of securities on stock exchanges. Unlike derivative products, the securities are 100% backed by physical gold held mainly in allocated form. These securities have had a major impact on the gold market, representing an annual average of 32% of identifiable investment and 6.5% of total physical demand over the 5 years to 2008. Still it is a long way to go, before Gold ETFs could become the most preferred instrument for investment in Gold.
Chapter 4: Analysis & Interpretation
Our analysis has shown that gold has been a terrible asset class had one invested at its last peak back in January 1980. The return that an investor would have got was just 44% as compared to a similar investment in S&P 500 with dividends reinvested, which would have yielded 2,100%! Hence, it is important that one invests in gold at the right time. And how does one ascertain what is the right time? The analysis done on the past data has shown that whenever the real interest rates have been negative, gold has proved to be a very good investment. Real interest rates (interest on a risk free government bond minus the inflation rate) were negative in the US between 1973 and 1980 and gold returned 32% per annum! Similarly, the median rate of interest has been negative since 2002 and today, a period where gold has returned nearly 19% on a compounded basis. Also, stocks turn out to be a bad investment if gold soars and vice versa. Please remember that this is the US market that we are talking about and things could be different in India. Any idea what will gold do in 2010?
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Role Of Gold In Indian Monetary System Well, it looks highly unlikely that US Fed will raise interest rates significantly. In other words, real interest rates are likely to remain in the negative zone, thus clearing the field for gold to go even higher. FIGURE 8: Gold gives best Return When?
The detailed analysis makes me believe that return to the gold standard represents the best possible situation. Investors around the world are losing faith in the dollar and the problem lies with its management. The dollar is a glorious old brand that's looking more and more like General Motors.
4.1 Gold and inflation
The value of gold, in terms of the real goods and services that it can buy, has remained largely stable for many years. In 1900, the gold price was $20.67/oz, which equates to about $503/oz in today's prices. In the five years to end-December 2008, the price of gold averaged around $606. So the real price of gold has endured a century characterized by sweeping change and repeated geo-political shocks and more than retained its purchasing power. In contrast, the real value of most currencies has generally declined. FIGURE 9: Currencies in terms of Gold
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Investors in gold can point to a growing body of research supporting gold's reputation as a protector of wealth against the ravages of inflation. Market cycles come and go, but extensive research from a range of economists has demonstrated that, over the long term, through both inflationary and deflationary periods, gold has consistently maintained its purchasing power. In the short run, experience has shown that gold can deviate from its long-run inflation-hedge price, and, when enjoying a sustained buoyant period, as is currently the case, can offer opportunities for impressive returns.
4.2 Adequacy of Foreign Exchange Reserves
Traditionally, the adequacy of foreign exchange reserves was measured by the import cover. About three to four months of import cover was considered adequate. However, the South East Asian Crisis questioned the validity of this measure. The crisis lasted for a long period and a few months import cover was insufficient to absorb the external shock. In addition, the integration of global financial markets has facilitated a free flow of capital across the geographical boundaries of the countries. This has created a need for fresh measures of foreign exchange reserves adequacy. The measure needs to take into account a number of parameters like size, composition and risk profiles of various types of capital flows. It also needs to consider the various types of external shocks that a country is exposed to. Aizenman and Marion (2003) argue that reserve holdings in the period 1980 to 1996 could be explained by ‘traditional factors’, but had become significantly underestimated since the Asian crisis. The High Level Committee on Balance of Payments chaired by Dr. C. Rangarajan had suggested that payment obligations should be considered while determining the reserves adequacy in addition to import cover. Money-based and debt-based indicators were recommended in addition to trade-based indicators by the Report on Committee on Capital Account Convertibility. Invariably multiple indicators are to be used to assess the adequacy of reserves. Y.V.Reddy
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Role Of Gold In Indian Monetary System (2006) rightly summarizes: “Thus, while the traditional indicators of adequacy of reserves are based on trade, debt and monetary indicators, or even the ‘Guidotti Rule’ or ‘Liquidity at Risk’ Rule suggested by Alan Greenspan may help explain the adequacy of reserves, they need to be supplemented with, what may be described as, multiple indicators to assess the adequacy of reserves of any country at a given juncture.” (p.1) The import covers of reserves, the traditional trade-based indicator of reserve adequacy, was at the lowest at 3 weeks in December 1990. This improved to 11.5 months of import in March 2002, only to rise further to 14.2 months in March 2003. The import cover of reserves stood at 17.0 months at the end of March 2004. Subsequently, it declined to 14.3 months in March 2005 and further to 11.6 months in March 2006. The ratio of short-term debt to foreign exchange reserves declined from 146.5% at the end of March 1991 to 5.3% at the end of March 2005 and to 7.0% at the end of March 2006. The ratio of volatile capital flows (which includes cumulative portfolio inflows and shortterm debt) to reserves dropped from 146.6% as at end-March 1991 to 35.2% as at end- March 2004. The ratio registered a moderate increase and stood at 36.6% at the end of March 2005. It was at 43.2% at the end of March 2006. Three to four months import cover is considered fairly adequate. Rodrik and Velasco (1999) and Garcia Soto (2004) argue that typically a country is considered prudent if it holds foreign currency reserves in the amount of its total external debt maturing within one year. IMF (2003) also suggests that a ratio of reserves to short-term foreign debt much above one does not further reduce the risk of a crisis. India seems to hold foreign exchange reserves very much in excess of what is suggested as adequate by these measures. India is not alone in the crowd of countries that hold excess reserves.
TABLE 7: Emerging Market Adequacy Reserve Ratios
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TABLE 8: Excess Reserves of Countries
Summers (2006) argues that the wealth tied up in reserves, if invested either domestically in infrastructure or in a fully diversified portfolio in the global capital markets for a longterm, can fetch 6%. The resulting gain could be estimated to be around US $100 billion a year. The opportunity cost of the aggregate reserves of the 10 leading holders of excess reserves works out to 1.85% of their combined GDP. He says if India were
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Role Of Gold In Indian Monetary System to invest the foreign exchange reserves in global capital markets, the extra returns that would result could be between 1 and 1-1/2% of GDP each year. If annualized and valued as a stock, it is around 40% of the market value of all the traded stocks on the Bombay stock exchange.
4.3. India’s Concerns in Managing Foreign Exchange Reserves
India is faced with a current account deficit unlike many other emerging economies. The current account deficit has increased from US $5.4 billion in 2004-05 to US $10.6 billion in 2005-06. As a proportion to GDP this is an increase from 0.8% to 1.3%. This is an indication of growing openness and integration of the Indian economy with the global economy. The ratio of current receipts to GDP grew increased from 22.0% in 2004-05 to 24.5% in 2005-06. Similarly, trade openness measured as the ratio of merchandise exports and imports to GDP increased from 28.9% during 2004-05 to 32.7% in 2005-06. (RBI Annual Report, 2005-06) With the growth of domestic industry and higher oil prices in the international markets this current account deficit may be expected to widen in the coming years. This will require more foreign exchange reserves to manage the foreign exchange demand that will arise from current account transactions. As mentioned earlier, the major source of accretion to foreign exchange reserves in India is portfolio capital flows. Foreign investment flows into India comprises of Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). The cumulative foreign investment flows which were very negligible in 1990-91 registered a huge rise and were at US $106 billion in 2005-06. The share of FDI was US $49 billion and that of FPI was US $57 billion. From 1993-94 to 1997-98, the FDI flows exceeded the FPI flows. But, subsequently the trend had reversed. The rise in FPI flows had been particularly sharp since 2003-04. During 2003-04, their share of total foreign investment inflows was at 79.4%. It stood at 68.2% in 2005-06. FPI flows are considered less stable than FDI flows. Hence, with the expansion of FPI flows, an increasing level of foreign exchange reserves is required to be kept liquid to ward off any sudden shocks of capital flight. RBI’s approach to reserves management is summarized in the RBI Annual Report, 2006 as follows: “ The overall approach to the management of India’s foreign exchange reserves takes into account the changing composition of the balance of payments and endeavors to reflect the ‘liquidity risks’ associated with different types of flows and other requirements. The objectives of reserve management in India are preservation of longterm value of the reserves in terms of purchasing power and the need to minimize risk and volatility in returns” (p.102). Hence, gold being highly liquid can serve this purpose. 10. Issues in increasing Share of Gold in Indian Foreign Exchange Reserves Given the precautionary motive of holding foreign exchange reserves in India, as is evident from the high level of deposits with banks, gold can be a prominent asset in the portfolio. What should be the quantum of increase? The international average for the share of gold in the foreign exchange reserves is around 10.5%. While the European countries have over 40%, USA has over 70%. But, the share of gold in Asian countries has been well below the level that India holds. In India, the share of gold is less than 5%. This is in line with many of the Asian economies.
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Role Of Gold In Indian Monetary System As mentioned earlier India is accumulating foreign exchange reserves to meet the requirements of its increasing current account deficit and to protect against volatile capital flows. Though this purpose is served by gold there are other issues. For an emerging economy like India, the reserves should work and earn yield. Keeping large amounts in precious metals which do earn a very low yield cannot meet this objective. If India were to increase the proportion of gold in its foreign exchange reserves to 10%, it would require an outflow of about US $15 billion at the current level of gold prices. Can India afford this is a question to be answered. Though gold is described as a liquid asset, its liquidity vis-à-vis foreign exchange market is low. Average daily turnover in gold is around US $7.3 billion while that of the foreign exchange market is US $1200 billion. Hence, exiting large physical quantities of gold in case of an emergency may is one difficult and secondly will not go unnoticed by the market watchers. To conclude, while it is a clear fact that gold can help diversify and hedge the foreign exchange reserves, how much of it should be held has to be decided carefully given the economic circumstances of an emerging economy like India.
4.4 Gold and risk
Financial instruments usually carry three main types of risk. · Credit risk: the risk that a debtor will not pay · Liquidity risk: the risk that the asset cannot be sold as a buyer cannot be found. · Market risk: the risk that the price will fall due to a change in market conditions. Gold is unique in that it does not carry a credit risk. Gold is no one's liability. There is no risk that a coupon or a redemption payment will not be made, as for a bond, or that a company will go out of business, as for an equity. And unlike a currency, the value of gold cannot be affected by the economic policies of the issuing country or undermined by inflation in that country. At the same time, 24-hour trading, a wide range of buyers - from the jewellery sector to financial institutions to manufacturers of industrial products - and the wide range of investment channels available, including coins and bars, jewellery, futures and options, exchange-traded funds, certificates and structured products, make liquidity risk very low. The gold market is deep and liquid, as demonstrated by the fact that gold can be traded at narrower spreads and more rapidly than many competing diversifiers or even mainstream investments. Gold is of course subject to market risk, as is clear from the experience of the 1980s when the gold price declined sharply. But many of the downside risks associated with the gold price is very different to the risks associated with other assets, a factor which enhances gold's attractiveness as a portfolio diversifier. For example, should a central bank announce its intention to engage in substantial sales of gold, as happened prior to the Central Bank Gold Agreement in 1999; this would be unlikely to have an impact on equity returns but could reasonably be expected to affect the gold price in the short run. Similarly, the specific risks to which bonds
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Role Of Gold In Indian Monetary System and equities are exposed, including pressure on the health of the government and corporate sector during an economic downturn, are not shared by gold. One measure of market risk is volatility, which measures the dispersion of returns for a given security or market index. The more volatile an asset, usually the riskier it is. The gold price is typically less volatile than other commodity prices. This is because of the depth and liquidity of the gold market, which are supported by the availability of large above-ground stocks of gold. Because gold is virtually indestructible, nearly all of the gold which has ever been mined still exists, much of it in near market form. This means that sudden excess demand for gold can usually be satisfied with relative ease. And, unlike many other commodities such as, for example, oil or platinum, the geographical diversity of modern mine production further reduces the chances of supply shocks from any specific country or region having an undue impact on the price. As a consequence, gold is generally slightly less volatile than heavily traded blue-chip stock market indices such as the FTSE 100 or the S&P 500. Gold's extensive appeal and functionality, including its characteristics as an investment vehicle, are underpinned by the supply and demand dynamics of the gold market.
4.5 Gold as a tactical inflation hedge and long term strategic asset
While 2008 was marked by deflation fears, the first half of 2009 saw a growing number of investors express concern over the prospect of resurgence in inflation. Their fears emanated from the aggressive policy responses that were put in place around the world to deal with the financial crisis, alongside tentative signs that the worst of the recession might be behind us. If inflation does materialize, then traditional inflationhedges like gold, commodities, real estate and inflation-linked bonds are likely to outperform other mainstream financial assets. Nonetheless, some investors may be reluctant, at this stage, to add/increase their exposure to specific assets that are recognized as performing well during periods of high inflation, as there are currently equally compelling reasons for inflation to remain low, not least the bleak outlook for consumer spending. This leads us to ask whether any of the four traditional assets that are perceived to perform well during a high inflation environment could demonstrably enhance investors’ risk-adjusted returns even in a low to medium inflation environment, yet provide investors with the peace of mind that they have an asset in their portfolio that is likely to outperform should inflation materially accelerate. Using a portfolio optimizer, we examined the relative performance of four traditional inflation hedges on this basis, over three historical periods and in a forecast scenario, using conservative real return assumptions for each of the inflation hedges. In two of the three historical scenarios, gold proved more effective than commodities, real estate and TIPS, at achieving both the maximum reward-risk portfolio and the minimumvariance portfolio. The required allocation to gold in the portfolio mix to attain minimum variance ranged
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Role Of Gold In Indian Monetary System from 4.0 to 6.3%, while the allocation required achieving the maximum reward-risk ranged from 7.0 to 9.9%. A 6.9% allocation to gold also produced the highest reward-risk portfolio in the forecast scenario, while an allocation to TIPS produced the lowest variance portfolio. We also found a strategic case for gold in the portfolio of an investor that already holds TIPS, thanks to the additional diversification benefits gold brings to a portfolio. Looming inflation and the gold price If inflation is on the horizon it raises important questions for portfolio managers, as traditional assets like fixed-income bonds and equities are not known for their outperformance during periods of high inflation. Investors instead tend to flock to “real” assets or assets that are specifically designed to track inflation. The four most commonly purchased inflation hedges are arguably: gold, commodities in general, real estate and inflation-linked bonds. The last are similar to traditional government or corporate bonds, but with the coupon and principal repayments tied to changes in the general price level, typically the country’s official consumer price index. FIGURE 10: Annual Growth of Gold Prices
Gold’s history as an inflation hedge spans centuries. A cursory glance at gold’s performance in the years since The Golden Constant was first published shows an intuitive relationship between changes in the gold price and changes in the US consumer price index, with peaks in the gold price tending to lead peaks in the CPI.
4.6 Gold in present Market Scenario
Evil-day gold buying really motored since the credit collapse began in August 2007. Soaking up investment dollars worldwide, in fact, new allocations to the metal – whether trust-fund or owned outright – swelled by
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Role Of Gold In Indian Monetary System 38% during the first quarter of 2009 compared with total demand between Jan. and March 2008, according to marketing-group the World Gold Council (WGC). Within that figure, what the GFMS consultancy (who supply the WGC with its data) calls "identifiable investment" leapt 248% compared to Q1 '08. And Gold ETFs made the headlines once more, sucking in "another quarterly record" as new inflows required 465 tonnes of metal to back them, thus dwarfing the previous record of 149 tonnes set in the third quarter of last year. FIGURE11: Gold as a percentage of total Assets
It makes a nice pie chart, and it offers a useful snapshot of different asset classes vs. each other. But here at BullionVault, we also think the idea's worth refining. Because this estimate both over-states liquid assets in toot and under-estimates the stock of gold available to investment flows–whether retail or wholesale. First, note the scope for double-counting between pension, mutual and insurance funds. I'm not saying the WGC's data trips up on that error, but you can see how likely it seems given the end-allocation categories applied. For instance, "hedge funds" are stripped out separately (as are REITs and private-equity), even though institutional allocations via funds-of-funds will be counted elsewhere under the broader "funds" title. Similarly, but more pertinent, the outstanding quantity of "gold – investment stocks" underplays the true volume of metal held as a store of wealth. Simply counting the "investment" volume excludes fully 84% of the above-ground supply, as another chart from the WGC's presentation shows.
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Role Of Gold In Indian Monetary System
FIGURE12: Above ground Stocks
Why not also include "official sector" gold hoards? Sovereign wealth funds and FX reserves were included on the other side of the ledger, after all. More crucially still, why not include jewelry? Trying to split out the volume of trinkets held for aesthetics alone might feel easy enough to a Western analyst just back from window-shopping at Mapping & Webb. But across south-east Asia, and most particularly in India – typically the world's No.1 destination for physical gold each year – large, chunky necklaces and bracelets make for "investment jewelry", acting as a store of wealth in the absence of any formal banking network. In 1968 gold may have represented 4.5% to 5.0% of the world's wealth...By the 1990s it was down to 0.2% of the world's wealth. Not that gold was falling in value so much as the other wealth – stocks, bonds, paper assets, government bonds, corporate bonds, bank deposits – were exploding once the tie to gold was severed. In 2006 gold represented 0.2% of world wealth. At the end of 2007, it was about 0.4%. Depending on what you think about wealth destruction in 2008, it may have been 0.6%. That figure just about matches the WGC's estimate of 0.7% (perhaps they used the same inputs and excluded the same volumes of central-bank and jewelry gold?). It also contrasts with our own Estimate of Gold as
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Role Of Gold In Indian Monetary System a Proportion of Investable Wealth at nearer 2.7% by the close of 2008...which itself shows gold remaining significantly under-invested right now compared with the last two peaks of global investment panic, 1982 and 1932. Does that in itself make gold a buy? Of course not. But compared to the evil days of 1930s depression – or the fearful inflationary panic of the late 1970s – the world's wealth remains very under-invested in metal right now.
4.7 Correlation of Gold prices with various other commodities
TABLE 9: Correlation of Gold prices with various other commodities
Two periods seem to indicate that the relationship between commodities and the dollar becomes stronger during times when the latter is weakening. One possible explanation why this could be the case is that during times of dollar weakness investors diversify part of their capital away from dollar-linked assets. This move can benefit investments in commodities (and in fact has done so in the past), boosting the negative relationship between the two. Moreover, during the 2002-2004 period, the commodities complex received exceptional attention from the financial media, which certainly boosted the sector’s popularity with investors.
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Role Of Gold In Indian Monetary System The unimpressive performance that equity markets demonstrated over parts of the period was another factor that certainly gave commodities further relative appeal. The increased investor involvement in the sector resulted in commodity prices being in greater part driven by speculative activity, boosting the strength of the negative correlation of prices with the US dollar, which was declining at the same time for different reasons. Another interesting fact is that the coefficients calculated for the different commodities vary greatly. The majority of them seem too low to indicate a significant link exists. Performing a statistical test confirms this, and in fact shows that only four commodities’ coefficients are significant for the first period examined, while eight are significant for the second. The commodities that demonstrated significant correlation with the dollar over the first period were cocoa, gold, aluminium and lead. Over the second period, they were gold, silver, unleaded gasoline, corn, soybeans, crude oil natural gas and platinum. Interestingly, none of the coefficients that were found to be significant were positive, in accordance to our expectations (basis the conjecture that, if anything, commodities are expected to be negatively correlated with the dollar). At -0.51, the correlation coefficient calculated between gold and the dollar for the latter period dwarfs all the other statistics we calculated for this section. The second strongest link in the list, the one with silver, is significantly weaker, the correlation coefficient being -0.37. All other coefficients we calculated stood at -0.21 or lower (in absolute terms). It is worth a mention, furthermore, that gold was the only commodity with a significant correlation coefficient over both periods examined. It would thus seem to be the case that, basis the sample examined; gold is a better hedge against the dollar than other commodities. This comes as no surprise, as the yellow metal has always been considered to have an inverse relationship with the greenback4. This relationship is to a large extent self-fuelled, due to investors trading on the back of it. Moreover, the correlation coefficient between the yellow metal and the dollar over the first period examined is a mere –0.19. The difference between the coefficients calculated over the two periods is thus more pronounced for gold than for the other commodities (with the exception of silver, which is discussed later in this report). This fact is in accordance with a known practice in the investment world, that of the “flight to quality”. The term refers to the action of investors moving their capital away from riskier or more volatile assets and into ones considered to be safer and less volatile. The move tends to take place during times of uncertainty in the financial markets and world economy, and reflects some investors’ risk aversion. The second highest (in absolute terms) correlation coefficient calculated was the one between silver and the dollar over the 2002-2004 periods. It is our understanding that the link between the two is indirect and
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Role Of Gold In Indian Monetary System primarily stems from the relationship between gold and silver prices, which GFMS have documented in past publications5. This point is discussed further in later sections of this report. Having examined changes in the prices of the two metals, we have concluded that these show significant positive correlation. As mentioned previously, the remaining six commodities with significant correlation coefficients showed much weaker links to the US currency. Furthermore, none of the six were significant over both periods examined. We can thus deduce that their ability to provide a hedge against changes in the US dollar is very limited compared to gold and, to an extent, silver.
Gold market Report by data monitor Following key points can be highlighted: Market Value The global gold market grew by 18.4% in 2008 to reach a value of $67.2 billion. Market Value Forecast In 2013, the global gold market is forecast to have a value of $75.2 billion, an increase of 11.9% since 2008. Market Volume The global gold market shrank by 4% in 2008 to reach a volume of 2,434.6 metric tonnes. Market Volume Forecast In 2013, the global gold market is forecast to have a volume of 2,436.9 metric tonnes, an increase of 0.1% since 2008. The above clearly shows that the volume of gold is not going to increase too much, but the demand is going to increase. As the result the price is bound to rise.
4.8 Gold Mining Supply 2009
FIGURE 13: World Gold Mining Output Vs Gold Price
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In 2009, Gold mining supply worldwide has failed to grow during the seven-year bull market in gold – and failed badly. Global gold mining output peaked in 2003. Even the record gold price of 2008-09 saw world supply fall. Investors have moved heavily into gold mining companies even as the industry has struggled with declining production. The top 10 gold mining corporations with a combined market capitalisation of nearly $180 billion have seen over 140 per cent returns on their shares, with some giving more than 200 per cent. There have been few new finds which are generally low grade and expensive to develop. The cost & time of bringing new mines into production has escalated dramatically. Also, given the current financial crisis, money is difficult to find for exploration and mine development projects. TABLE 10: Top Gold Mining Companies
In 2004, the top three gold producing countries in the world: 1. South Africa
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Role Of Gold In Indian Monetary System 2. United States 3. Australia In 2008, the top Ten Gold Producing Countries in the world:
1. China – 12.20% 2. USA - 9.90% 3. South Africa – 9.80% 4. Australia – 9.60% 5. Peru – 7.40% 6. Russia – 7% 7. Canada – 4.20% 8. Indonesia -3.80% 9. Uzbekistan – 3.60% 10. Ghana – 3.40%
FIGURE 14: 2008 Gold Production
Source:http://gold.infomine.com/countries/ We increasing demand & decreasing supply, the price of Gold is bound to rise in future. Any new exploration is not going to produce any gold before next five year. As in past, Gold is going to play a major role in enhancing the economy of the gold exporting countries. Gold mining's value to developing countries: Developing countries account for 72% of global output. Most of this come from the low-income or lowermiddle-income countries that together account for two third of the global output. Of the 38 Heavily Indebted Poor Countries (HIPCs), 14 are significant gold producers. For HIPCs as a group, gold accounted for nearly 8% of goods exports and over 6% of exports of goods and services. It is
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Role Of Gold In Indian Monetary System one of the most important exports for HIPCs. Gold is the leading export for Mali (59% of goods exports in 2003), Tanzania (44%), Ghana (32%), Guyana (26%) and the second most important for Guinea (23%). A $10 fall in the gold price would cause a loss of around $75m in HIPCs' export income. Gold is equally important to other low-income countries that are not HIPCs. Among those considered by the World Bank to be severely or moderately indebted, gold is the leading export for Kyrgyzstan (around 45% of total goods exports in 2003) and Papua New Guinea (36%), the second most important export for Mongolia (20%) and Zimbabwe (11%) and one of the two leading exports for Uzbekistan. Among lowermiddle-income countries, gold is the leading export for both South Africa (13% of goods exports in 2003) and Peru (17%). Gold mining companies source supplies locally where possible and employ local labour where possible. Thus, even allowing for some necessary imports and for the remittance of profits and dividends, their impact on a developing country's balance of payments is strongly positive. Export revenue is not the only benefit gold mining brings to a developing country. It provides royalty and tax income to governments, technology transfer, skilled employment and training for local populations, together with further jobs through the multiplier effect. In one or two cases it has provided the foundation for a significant jewelry manufacturing industry. Gold mining can also bring substantial improvements in physical, social, legal and financial infrastructure. The establishment of a formal mining industry can be the first step in a country's industrial development. Mining is a foundation industry that often provides the critical mass for the development of electricity, water, road and rail transport in a region. This characteristic of the industry is particularly important in Africa where lack of infrastructure has been identified as one of the major hindrances to economic development. Gold mining brings benefits to poorer nations. It will continue to have a role to play in fostering economic development. But the economic development may change hands, depending upon the largest exporter of Gold. Since the supply is decreasing, the nations where production would decrease can lead to increase in unemployment. Since the gold mining workforce is highly specialized, they might find difficult in finding new jobs.
4.9 Gold as tool to hedge against US Dollar currency
US dollar has lost more than 40 per cent of its value since 2001 as measured by the dollar index, which tracks the dollar against a basket of major currencies, including the euro, yen and pound sterling.
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Role Of Gold In Indian Monetary System FIGURE 15: Gold as tool to hedge against US Dollar currency
Source: London Bullion market - www.lbma.org.uk/ Foreign exchange (INR v/s Dollar) data & Gold price for the last fifteen years was collected and analysed. First, for the price of gold we used the daily London PM gold fix; this price is quoted in US $ per troy ounce. The fix is at 10:30 AM London time. The source for the raw data series is the London bullion market. While gold is traded in markets throughout the world, the market is essentially Homogenous since the price is always in dollars and the gold traded is “loco London” (gold deliverable in London and meeting London trading standards). The London PM fix is normally considered the main reference price for the day and is the price most often used in contracts. The gold fix takes place twice daily at 10.30am and 3pm, London time.
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Role Of Gold In Indian Monetary System The weekly gold price, which can be seen to range from about $400 at the beginning of 1995 to a maximum of $1100 in 2009. Such wide fluctuations are much greater than those observed in the exchange rates and it was therefore decided to transform the series by taking logarithms, which has the effect of compressing scale and hence stabilising the variance of the data. It could be seen from the above graphs, whenever the dollar value decreased, the gold price increased. Gold Price & dollar value are negatively correlated. Gold is indeed a hedge against fluctuations of the US$ on the foreign exchanges. The Theoretical Case for gold providing a hedge against the US Dollar Having established the statistical case for gold being superior to other commodities as a hedge against the dollar, it is interesting to examine the theoretical properties behind this attribute the metal seems to possess. What are the reasons that make gold is a suitable instrument for hedging against the US dollar, and more specifically, what are the reasons it is a more suitable instrument in this regard, compared to other commodities? • First of all, like all physical commodities, gold is an asset that bears no credit risk. Holding assets in the metal involves no counterparty and is no one’s liability. This of course does not apply to investments in paper gold products, which by definition involve an issuing institution. In addition to that, the physical properties of the metal make it an excellent alternative to money. Gold is durable. • Unlike many of the other commodities examined, other things remaining equal (i.e. assuming no changes in price), there is no depreciation in the value of gold, other than any storage costs that might apply. Gold is fungible • • It is, at least in theory, infinitely divisible with virtually no losses (other than any operational costs the process might incur). Furthermore, gold has a high value to volume ratio, which makes it easily transferable, with low transport and storage costs. Moreover, gold is one of the deepest commodity markets with the highest liquidity. At end-2004, above ground stocks of gold, defined as cumulative mine production, stood at roughly 153,000 tonnes (source: GFMS, Gold Survey 2005), translating to over $2.1 trillion (using the end-2004 gold price). As a point of reference, the equivalent figure for silver, the second most strongly correlated commodity to the dollar according to our analysis above, is less than $0.2 trillion. This liquidity of the gold market conveys financial characteristics on the metal, thus making it a suitable alternative to fiat money. The most important such property though, is gold’s legacy as a monetary commodity, and the fact that investors treat and trade it as one.
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Role Of Gold In Indian Monetary System For a great part of human history, large parts of the world accepted the metal as the ultimate store of value. In fact, it was not until the 1970s that gold stopped being the benchmark for the international currency market. After the move to a system of floating fiat currencies, and currency and inflation risk developed, so did the need to hedge against this risk, using some sort of hard, value-retaining asset. The natural choice for this was and has been the commodity that had in the past acted as such, namely gold.
4.9 Gold's value as a currency reserve
Gold is still considered an important reserve asset by most central banks, even though it is no longer the centre of the international financial system. The most important reason is that gold is the only reserve asset that is no one's liability. This means that, unlike a currency, the value of gold cannot be affected by the economic policies of the issuing country or undermined by inflation in that country. Gold has a track record of holding its real value over the centuries. Since gold is no-one's liability, it can not be repudiated and holding it is a safeguard against potential unforeseen crises. Gold also brings much needed diversity to a central bank portfolio due to its low correlation with key currencies and its strong inverse correlation with the US dollar. FIGURE 16: Gold reserves as the percentage of total reserves for United States
Gold reserves as the percentage of total reserves for United States FIGURE 17: Gold reserves as the percentage of total reserves for India
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Gold reserves as the percentage of total reserves for United Kingdom
Gold reserves as the percentage of total reserves for India FIGURE 18: Gold reserves as the percentage of total reserves for China
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Gold reserves as the percentage of total reserves for China
Source: Data for all graphs:http://www.reserveasset.gold.org/
RBI’s decision to shore up its gold reserves needs to be seen in the context of other central banks across the globe increasing their gold reserves. Among them are the central banks of China, Russia and a few countries in the European Union. In the last one year, China has increased its gold holdings, by weight, by 75.69%, Russia by 18.78%, the Philippines by 18.50% and Mexico by 108.91%. Compared with this, India’s central bank did not add anything to its gold reserves in the last one year, according to Bloomberg data. In fact, the share of gold in India’s total reserves has dwindled over the decade. In March 1994, the share of gold in the total reserves of the country was 20.86%; by the end of June 2009, gold constituted only 3.7% of the total reserves. RBI’s foreign currency assets consist mainly of sovereign bonds, mainly US treasuries. So, buying more gold will help the Indian central bank diversify its assets. Gold is the ultimate currency. In fact, only gold came to our rescue during (the) 1991 crisis, so it makes sense that RBI should try to increase its gold holdings. RBI's foreign exchange reserves consist of foreign currency assets, gold, special drawing rights (SDR) an international reserve currency floated by IMF and RBI funds kept with IMF. Out of RBI’s $285.5 billion foreign exchange reserves, foreign currency assets account for the most $268.3 billion followed by gold ($10.3 billion), SDR ($5,267 million) and reserve position in the IMF ($1,589 million). According to RBI’s latest annual report, the foreign currency assets consisting of foreign securities declined by Rs81,010.25 crore from Rs12.98 trillion on 30 June 2008 to Rs12.17 trillion on 30 June 2009 mainly due to net sales of dollars in the domestic foreign exchange market.
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Role Of Gold In Indian Monetary System At the current market value of $1,054 an ounce, or per 28.5g, RBI would need to spend about $7.4 billion to buy 200 tonnes of gold. With this, its gold reserve will rise to $17.716 billion, or roughly 6.20% of the total reserves.
4.10 Gold Consumption in India
India is the most lavish gold consumer in the world. No one can miss the sign of a gold shop, if he travels across any Indian city. A small village town called Chavakkad in central Kerala, a southern Indian state that consumes 20% of all gold sold in the country, has more than 115 glittering gold jewellery shops! And it is not just the village towns. Travel to Zaveri Bazaar, the nerve centre in Mumbai, India’s financial capital. Thousands of bullion traders and dealers carry out global trading in gold from here. Gold prices may be zooming world over. This week, the yellow metal glittered as it touched a record high of $1225 per ounce! Now, analysts from Jim Rogers to Jim Sinclair are predicting that gold is the hottest investment asset compared to the declining US dollar, and thus the yellow metal prices will soar above $2000 per ounce in the next decade, beginning 2010. But despite this huge rise in gold prices—the yellow metal prices gained by more than 39% in 2009— Indians continue to buy gold. They buy gold ornaments for the marriage of daughters. They buy gold jewellery during festival seasons. They buy gold coins from banks, post offices and brokerage houses and keep them in safe lockers as future investment. India remains the darling consumer of the bullion trading industry. No bullion analysis daily misses to mention India when it comes to gold trading, consumption and imports. According to an estimate from the World Gold Council (WGC), India is set to consumer or buy around 700 tonnes of gold in the year 2009. In 2008, India’s gold buying was higher at 900 tonnes. Bullion traders and WGC say that gold consumption has declined in India this year thanks to the skyrocketing prices of the yellow metal. Ditto is the case with India’s gold imports. Last year, India imported 712 tonnes of gold. Gold imports this year is expected to plunge to around 450 tonnes thanks to the dropping sales of gold on high price. India’s total gold holding is between 10,000 tonnes and 15,000 tonnes of which the Reserve Bank of India has only around 600 tonnes. While India is the proud, No 1 consumer of gold in the world, that golden status may move over to China by next year. Bullion analysts and WGC have already forecast that China may overtake India in gold consumption soon. Increased love of Chinese for gold may cause a huge rise in gold jewellery sales in
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Role Of Gold In Indian Monetary System China. According to market analysts, middle-class buyers in China, the second-biggest gold user, drove a 16 per cent gain in gold and silver jewellery sales in the first nine months. China’s economy grew 8.9 per cent in the third quarter, the fastest pace in a year, and the World Gold Council said in July that the nation may pass India as the biggest consumer. Bullion is on course for its ninth annual gain after the dollar weakened and demand for gold as a store of value increased. The Chinese have only started to buy gold as an investment product, and there’s huge room for this sector as the middle class grows.
4.11 Pattern of gold investment in India:
We conducted a small research to find out, what patterns/trends were visible in the investment patterns of Indians. The rate of savings of Indians has been on an increasing trend since 1970’s as indicated in the graph below. The GDP and the savings rate have been increasing proportionally.
FIGURE 19: The GDP and the savings rate of India
40% 35% 30% 25% Savings/GDP 20% 15% 10% 5% 0% FY71 -5% Gross Household Savings/GDP Private C orporate Savings/GDP Public Sector Savings/GDP GDP FY76 FY81 FY86 FY91 FY96 FY01 FY06 FY07 FY08 -200 1600 1400 1200 1000 800 600 400 200 0
Source:
Edelweiss Research report
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GDP (USD billion)
Role Of Gold In Indian Monetary System
On the other hand the gold prices show an increasing trend as shown in the graph below
Source: Timothy Green's Historical Gold Price Table , London prices converted to U.S. Dollars.
With the assumption that increasing prices of gold also reflect the household demand of gold in India, we can conclude that investment in gold has not been increasing at the rate of increase of GDP in India. The investment in gold has picked up around 2001 during times of the dot com bubble when the market was bearish towards the equity investments. Investment in gold also sees an increasing trend during 2007-08 when most of the major countries was reeling under recession. Indians like to keep major part of their investment in gold, but their rate of increase in gold has not kept pace with the increase in the disposable income/national income.
4.12 The gold versus equity
The precious metal’s recent spectacular run from sub-$1,000-per-troy-ounce-level in the international markets to record highs of over $1,055 per ounce. The metal has jumped by around 20% this year, and after this week’s massive rally, is all set to record its ninth consecutive yearly gain. In a span of just days, the metal first crossed the $1,000-mark and then topped its all-time record of $1,034 per ounce. In India, the world’s largest gold consumer and with one of most well-performing stock exchanges, a rupee invested in gold bars in 1998-99 would have given a return of around Rs 197 in 2008-09. This means, in 10 years, investment in 10 gm of gold bar in India would have risen by 197%. Around the same time, one rupee invested in the BSE sensitive index would have given a return of around Rs 345 by 2008-09.
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Role Of Gold In Indian Monetary Systemhttp://www.financialexpress.com/news/the-gold-versus-equity-story-is-changing/527832/In
other words, stocks have outperformed gold for most of the last decade, albeit minor aberrations like in 2002-2003 and 2001-2002 when the return on the BSE Sensex was less than that on gold. In 2006-07, RBI data shows that 10 gm gold prices in Mumbai rose around 34% as compared to last year while the 30-share BSE Sensex rose 48.3% as compared to the previous year. Similarly, in 2005-06, gold prices in Mumbai spot markets rose 12.3% as compared to the previous year, but the BSE Sensex climbed around 44.2%. In other words, in all these years, investment in stocks would have given a layman better returns than in gold. Experts believe that a big reason for this was that the years 2005 and 2006 were marked by high GDP growth rate in India that propelled stock markets to dizzying highs. Even a data from the World Gold Council (WGC) shows that in the last five years, returns on the main 200 stocks listed in the Bombay Stock Exchange (BSE) have grown.
FIGURE 20: Gold Rush
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Chapter 5: Conclusion
In the world’s financial and political capitals, India — now sitting on the fifth largest stash of foreign exchange among all countries — was seen to be flexing its muscles with its dramatic dollar-for-gold swap. But there’s another, even bigger, game in play here: Asian economies are hedging against a weakening US currency The reason is straightforward: faith in the world’s biggest economy, the US, and its currency is sliding. The US economy is beset with multiple problems — 10 per cent unemployment, a mind-boggling budget deficit, spiraling mortgage and credit card defaults, and persistent toxic assets on bank books — due in large part to years of unsustainable spending. By exchanging dollars for gold, India, China and other developing countries are hedging their bets, thus delivering an implicit vote of no-confidence in the dollar. In the past year, the dollar has declined by over 16 per cent, contributing in part to the increase in gold prices. With a big buyer like India stepping in and buying 200 tonnes of gold, both these trends received a fillip. The price paid by India virtually set a floor for international gold prices while further confirming the sentiment that the dollar was in trouble. US November data about increasing unemployment and foreclosures worsened the situation for the greenback. And hence gold is definitely going to play a major role in the future monetary system. The future role has been concluded below based on the analysis in this report:
5.1 Gold mining's value to developing countries
Gold mining is vital to the fragile economies of many impoverished countries, which account for roughly two-thirds of global gold production. In addition to generating export revenue in these countries, gold production provides royalty and tax income to their governments, technology transfer, worker training and the creation of a skilled workforce. Gold mining can also bring substantial improvements in physical, social, legal and financial infrastructure. In many of these countries, gold mining is a foundation industry that often provides the critical mass for the development of electricity, water, road and rail transport in a region, that are the essential foundations of an economy. Gold is often thought of as synonymous with wealth. Yet gold coins, bars and high-carat jewelry play a crucial role as a means of saving and defense against misfortune to many of the poor of the world. Similarly gold mining brings benefits to poorer nations. It will continue to have a role to play in fostering economic development.
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5.2 Gold as a preserver of value inflation hedge, safe haven.
While 2008 was marked by deflation fears, the first half of 2009 saw a growing number of investors express concern over the prospect of resurgence in inflation. Their fears emanated from the aggressive policy responses that were put in place around the world to deal with the financial crisis, alongside tentative signs that the worst of the recession might be behind us. If inflation does materialize, then traditional inflationhedges like gold, commodities, real estate and inflation-linked bonds are likely to outperform other mainstream financial assets. Nonetheless, some investors may be reluctant, at this stage, to add/increase their exposure to specific assets that are recognized as performing well during periods of high inflation, as there are currently equally compelling reasons for inflation to remain low, not least the bleak outlook for consumer spending.
5.3 Gold's value as a reserve
Gold is still considered an important reserve asset by most central banks, even though it is no longer the centre of the international financial system. The most important reason is that gold is the only reserve asset that is no one's liability. This means that, unlike a currency, the value of gold cannot be affected by the economic policies of the issuing country or undermined by inflation in that country. Gold has a track record of holding its real value over the centuries. Since gold is no-one's liability, it can not be repudiated and holding it is a safeguard against potential unforeseen crises. Gold also brings much needed diversity to a central bank portfolio due to its low correlation with key currencies and its strong inverse correlation with the US dollar. To conclude, while it is a clear fact that gold can help diversify and hedge the foreign exchange reserves, how much of it should be held has to be decided carefully given the economic circumstances of an emerging economy like India.
5.4 Gold's value in industrial applications
Gold ranks among the most high-tech of metals, performing vital functions in many areas of everyday life. Gold's unique properties make it useful in medical applications, pollution control, air bags, mobile telephones, laptop computers, space travel, and many other things we consider indispensable to our modern lives. Approximately 12% of demand for gold comes from industry
5.5 Gold's value as an effective portfolio diversifier
Gold is an effective hedge against inflation. In addition, gold is inversely correlated to the US dollar, making it a good currency hedge. As an asset class, gold has all the advantages of being universally regarded as a currency, without what are all too often the disadvantages of being subject to the economic and monetary policies of one particular country's government
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5.6 Gold's value to consumers and investors in developing countries
In much of Asia, the Middle East, and the Indian subcontinent, gold is the best possible protection against upheaval, both political and economic. For men and women throughout the developing world, gold is still one of the most liquid and widely accepted forms of exchange, quite simply the most efficient store of value they possess. Around two thirds of the jewelry purchased in the Middle East and Asia is used as a means of saving in addition to its function as an adornment. The use of jewelry as savings is often important in rural areas where access to a reliable and appropriate banking system is difficult or impossible. Gold also offers protection against a weak currency or high domestic inflation levels, which are prevalent and persistent problems in the developing world. Around two thirds of all jewelry manufacture takes place in the developing world and the proportion is rising. Countries such as Turkey, India, China and Thailand have all seen their exports to developed countries rise in the last few years, generating export earnings and employment. Gold jewelry sales to tourists are also important for Turkey, Egypt and Dubai.
5.7 In India, you’re in gold’s own country
The glitter of gold has attracted Indians for centuries for a variety of reasons — ranging from a medium of transaction to protecting wealth, securing the future and as jewellery. In the recent past, the volatility of the stock markets has only added to the luster of the yellow metal. The fact that gold has traditionally been considered a hedge against inflation and a depreciating dollar too has fuelled its demand. It is estimated that about 15,000 tonnes of gold is privately held in India, more than twenty-five times as large as the official hoard of 558 tonnes after the RBI’s recent purchase of 200 tonnes from the International Monetary Fund (IMF). Gold is valued in India as a savings and investment vehicle and is the second most prefered investment behind bank deposits. Gold purchases in Kerala and Tamil Nadu are almost exclusively meant for weddings, but among the relatively more market savvy Gujaratis, Marwaris and other business communities, gold buying is also driven by the metal’s attractiveness as an investment. Religiosity too seems to make common cause with the most universally recognized symbol of material wealth. Whether it’s for security, returns or other purposes, what’s clear is that India’s hunger for gold remains insatiable.
5.8 Impacting Factors affecting price of Gold
Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand, including hoarding and disposal. Unlike most other commodities, the hoarding and disposal plays a much bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price. Given the huge quantity of hoarded gold, compared to the annual
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Role Of Gold In Indian Monetary System production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production.
5.9 Future Outlook
The future of gold mining is dim. All the gold that has ever been extracted by humankind amounts to about 160,000 tonnes. There have been few new finds and most of the known deposits have been drawn down. Those that remain are generally low grade and expensive to develop. The cost of bringing new mines into production has escalated dramatically. The timeframe from exploration to production can be 5-10 years, which has slowed new production coming into the market. Also, given the current financial crisis, money is difficult to find for exploration and mine development projects. There is gold in seawater, but it would be too expensive to recover. You can actually turn lead into gold but the cost is prohibitive. So, with not much new gold coming in, and the international currency system on shaky legs, a new gold rush is on. Gold in all shapes, sizes and forms — bangles, bracelets, necklaces — is pouring into gold-refining centers, where it is converted into bars and ingots for investors who are looking to park their money in something more solid than the dollar.
5.10 So, Are we moving into bubble territory?
Gold prices could move considerably higher still if the “weight of money” entering the market from investors is sufficient. But signs of a bubble are apparent. For instance, the fact that scrap supply in some countries is now larger than local jewellery demand. The bubble could get a lot bigger, though, before it bursts, (but) that will be the eventual outcome. In the meantime, though, other central banks are expected take a cue from the RBI and look to diversify their foreign exchange portfolio — ie, sell dollars and buy gold. In the face of falling confidence in the dollar, the chairman of the Federal Reserve took the rare and unusual step of trying to “talk up” the currency — rare, because in the US it’s the treasury secretary who’s generally responsible for the health of the currency. The US can now only hope that India & China, despite their growing misgivings about the dollar, won’t pull the rug from under the currency since that would seriously affect the value of the trillion-plus dollars they have invested in US securities. It’s an irony that the fate of the dollar doesn’t really lie in America’s hands. It is countries such as China and India that are deciding what happens in currency markets. That’s even as they add a bit of glitter to their forex reserves.
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Chapter 6: Bibliography
• Aggarwal, R., 1992, Gold Markets, in: Newman, P., Milgate, M., Eatwell, J. (eds.) The New Palgrave Dictionary of Money and Finance (Vol 2), Basingstoke, Macmillan, pp. 257-258. • Aizenman, J. and N. Marion, 2003, The High Demand for International Reserves in the Far East: What is Going On?, Journal of the Japanese and International Economics, 2003, 17/3, pp.370-400. • Archer, D. and J. Halliday, 1998, The Rationale for Holding Foreign Currency Reserves, RBZN Bulletin, 61(4), 346-354. • Chopra, A., C. Collyns, R. Hemming, K. Parker, W. Chu and O. Fratzscher, 1995, India: Economic Reforms and Growth, IMF Occasional Paper 134, International Monetary Fund, Washington. • Ghosh, D., E.J. Levin, Macmillan, Peter and Wright, R. E. (2002), Gold as an Inflation Hedge, Department of Economics, University of St. Andrews in its series Discussion Paper Series, Department of Economics with number 0021, Macmillan. • • • • • • • • • Garcia, P. and C. Soto, 2004, Large Hoarding of International Reserves: Are They Worth It?, Central Bank of Chile Working Paper No. 299 International Monetary Fund, 2003, Are Foreign Exchange Reserves in India too High?, World Economic Outlook, September, Washington. International Monetary Fund, 2004, Guildelines for Foreign Exchange Reserves Management, Washington. Kim Y., 2000, Causes of Capital Flows in Developing Countries, Journal of International Money and Finance, 19, 235-253. Mani, G. and Vuyyuri S., 2004, Gold Pricing in India: An Econometric Analysis, athttp://ssrn.com/id=715841 Mohanty, M.S., P. Turner, 2006, Foreign Exchange Reserve Accumulation in Emerging Markets: What are the Domestic Implications?, BIS Quarterly Review, 39-52. Nugee, J., 2000, Foreign Exchange Reserves Management. Handbooks in Central Banking No. 19, London: Centre for Central Banking Studies, Bank of England. Reddy, Y.V., 2006, Foreign Exchange Reserves – New Realities and Options, available at www.bis.org/review/r060921c.pdf Rodrick D. and A. Velasco., 1999, Short Term Capital Flows, NBER Working Paper No. 7364. Page 74
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• Summers, L.H., 2006, Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation, L.K. Jha Memorial Lecture, Reserve Bank of India, available at www.rbidocs.rbi.org.in/rdocs/publications. • Williams, D., 2003, The Need for Reserves: How Countries Manage Reserve Assets, 3344, London: Central Banking Publications. • • • • Gold Production and Consumption Indices by Gold Field and Mineral Services Ltd BRIC report, BRIC and the world Commodities market World Gold Council, IIFL Research RBI and
Links:http://goldnews.bullionvault.com/gold_fear_052120093http://www.reuters.com/article/idUSTRE51N2PO20090224http://news.goldseek.com/SpeculativeInvestor/1171382460.phphttp://hubpages.com/hub/Why-to-invest-in-GOLD-and-How www.utilisegold.com
www.gold.org.inhttp://www.kitco.com/charts/historicalgold.html www.goldbarsworldwide.com www.bullionVault.comhttp://www.kitco.com/charts/historicalgold.html
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Chapter 7: Appendix
Questionnaire:
Name: Marital Status: Single/Married
Gender: Male/Female Age: years
1.
What is your Occupation? a) Salaried
b) Self Employed c) Student
d) Others
2.
What is your annual income? a) < Rs 120000
b) Rs 120000-Rs 250000 c) Rs 250000-Rs 500000
d) Rs 500000-Rs 1000000 e) > Rs 1000000
3.
What percent of your annual income do you save? a) < 10%
b) 10%-20% c) 20%-30%
d) 30%-40% e) > 40%
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4.
What is your primary investment objective? a) Highest potential returns
b) Growth of Income c) Income
d) Preservation of Capital
5.
What is your investment horizon? (Time until you need to withdraw cash from your investments) a) More than 10 years
b) 5-10 years c) 2-5 years
d) 1-2 years e) Less than 1 years
6. How predictable (or stable) and sufficient is your source of income? a) Unpredictable, making it difficult to budget or invest
b) Somewhat predictable, but can fluctuate from month-to-month c) Reasonably predictable, with some excess to invest from time-to-time
d) Predictable and sufficient to allow for periodic investment e) Very predictable with large excess to invest on regular basis
7.
What all investments you are aware of (Tick)? a) b) c) d) e) f) g) h) i) j) Equity/Shares Non Convertible Debentures/Bonds Bank Deposits/Saving Account/ Recurring Account Provident Funds/Pension Schemes Life Insurance Mutual Funds Commodity Trading Gold Deposits Real Estate Fixed Deposits(FDs)
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8. From the above investments rank it on the basis of your priorities? Codes a) Equity/Shares b) Non Convertible Debentures/Bonds c) Bank Deposits/Saving Account/ Recurring Account d) Provident Funds/Pension Schemes e) Life Insurance f) Mutual Funds g) Commodity Trading h) Gold Deposits i) Real Estate j) Fixed Deposits(FDs) E NCDs BD PF LI MF CT GD RE FD Rank %age of Investment
9.
Fill the boxes below with the codes of the investment given above, According to your perception of risk & return associated with it: Return Risk
High (Greater than 30%) Medium (11-30%) Low (20%
b) 10%-15% c) 5%-10%
d)
Documentation describes the role of gold in the Indian monetary system. It also explains the factors influencing the price of gold.
A Perspective On “Role of Gold in Indian Monetary System”
Role Of Gold In Indian Monetary System
Acknowledgement
We would like to express our deep and sincere gratitude to our beloved Director Mr. K.S. Subramaniam for giving us this opportunity to complete our research project.
This acknowledgement can’t be completed without conveying our sincere gratitude to Professor Anant Gupta (Deputy Director & the Head of Department, Finance, SCMHRD) for providing us with right direction and opportunity to complete our research project. We would also like to thank Dr. Neha Parashar, Ass. Professor, SCMHRD, for mentoring us throughout the length and breadth of the project’s duration. Her words of wisdom and guidance at every meeting helped us to tread on the right path and helped us immensely in getting the right work done on time. Without her, this paper would have been far from complete. At last I would like to thank all the faculties, students and people who were directly or indirectly were part of this project and helped us make our endeavor, a successful one.
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Role Of Gold In Indian Monetary System
Contents
Acknowledgement...................................................................................................................... 2 Contents..................................................................................................................................... 3 Preface.......................................................................................................................................7 Chapter 1: Introduction.............................................................................................................. 8 1.1 Gold Standard:...............................................................................................................10 1.1.1 Gold Specie Standard:...............................................................................................10 1.1.2 The Gold Exchange Standard....................................................................................11 1.1.3 The Gold Bullion Standard.........................................................................................11 1.2 The Bretton Woods System.............................................................................................11 1.3 History of the New Monetary System..............................................................................12 1.4 Dollar Problems:..............................................................................................................14 1.5 Actions Underway for Change.........................................................................................14 Chapter 2: Review of Literature...............................................................................................15 2.1 Factors Influencing the price of Gold...............................................................................15 2.1.1 Weak US Dollar ........................................................................................................16 2.1.2 Growth in Demand for Jewelry..................................................................................17 2.1.3 Increase in demand for exchange traded paper backed products............................17 2.1.4 Other factors leading to the variation in Gold Prices are:.........................................17 2.4.2 Street TRACKS Gold Shares – ETF Gold fund on NYSE...............................................19 2.5 Indian Foreign Exchange Reserves..................................................................................19 2.5.1 Official Stock of Gold.................................................................................................20 2.5.2 Gold as a Reserve Asset............................................................................................22 2.5.3 India’s reserves’ position and movement since Independence.................................24 ........................................................................................................................................... 26 2.5.4 India’s Accumulation of Foreign Exchange Reserves................................................26 2.5.5 Sources of Accretion to Foreign Exchange Reserves.................................................27 2.5.6 Components of Indian Foreign Exchange Reserves..................................................27 Page 3
Role Of Gold In Indian Monetary System
2.6 Gold Market Report by Data Monitor...............................................................................28 2.6.1 Research Highlights.................................................................................................. 28 2.6.2 Market Analysis.........................................................................................................29 2.6.3 Portfolio diversification..............................................................................................29 2.6.4 Gold and the dollar....................................................................................................31 2.6.5 Consumption and Production of gold across countries..............................................31 2.6.6 Consumption of gold across BRIC nations:................................................................34 2.7 Future of gold investments in India:................................................................................35 2.8 Gold and the international monetary system – a chronology..........................................36 Chapter 3: Research Methodology...........................................................................................39 3.1 Research Objective.........................................................................................................40 3.1.1 Primary Research Objective (PRO)............................................................................40 3.1.2 Secondary Research Objectives (SRO)......................................................................40 3.2 Tools Used....................................................................................................................... 40 3.3 Sample ..........................................................................................................................40 3.4 Research Methodology:...................................................................................................41 Chapter 4: Analysis & Interpretation.......................................................................................43 4.1 Gold and inflation............................................................................................................ 44 4.2 Adequacy of Foreign Exchange Reserves.......................................................................45 4.3. India’s Concerns in Managing Foreign Exchange Reserves...........................................48 4.4 Gold and risk................................................................................................................... 49 4.5 Gold as a tactical inflation hedge and long term strategic asset.....................................50 4.6 Gold in present Market Scenario.....................................................................................51 4.7 Correlation of Gold prices with various other commodities.............................................54 4.8 Gold Mining Supply 2009................................................................................................56 4.9 Gold as tool to hedge against US Dollar currency...........................................................59 4.9 Gold's value as a currency reserve.................................................................................62 4.10 Gold Consumption in India............................................................................................65 4.11 Pattern of gold investment in India:..............................................................................66
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Role Of Gold In Indian Monetary System
4.12 The gold versus equity..................................................................................................67 Chapter 5: Conclusion.............................................................................................................. 70 5.1 Gold mining's value to developing countries...................................................................70 5.2 Gold as a preserver of value inflation hedge, safe haven...............................................71 5.3 Gold's value as a reserve................................................................................................71 5.4 Gold's value in industrial applications.............................................................................71 5.5 Gold's value as an effective portfolio diversifier..............................................................71 5.6 Gold's value to consumers and investors in developing countries..................................72 5.7 In India, you’re in gold’s own country.............................................................................72 5.8 Impacting Factors affecting price of Gold........................................................................72 5.9 Future Outlook................................................................................................................73 5.10 So, Are we moving into bubble territory? .....................................................................73 Chapter 6: Bibliography............................................................................................................74 Links:.....................................................................................................................................75 Chapter 7: Appendix................................................................................................................ 76
List of Figures
Figure 1: Global Gold Market Value----------------------------------------------------------------------------------27 Figure 2: 5-Year Correlation of Weekly returns---------------------------------------------------------------------28 Figure 3: Gold and the trade-weighted Dollar----------------------------------------------------------------------- 29 Figure 4: Production and Consumption Weighted Real Gold Pric------------------------------------------------31 Figure 5: BRIC’s Gold Consumption----------------------------------------------------------------------------------33 Page 5
Role Of Gold In Indian Monetary System
Figure 6: Bar Chart- Gold Deposits of different Income Levels---------------------------------------------------39 Figure 7: Forms of Investment in Gold--------------------------------------------------------------------------------40 Figure 8: Gold gives best Return When? -----------------------------------------------------------------------------41 Figure 9: Currencies in terms of Gold---------------------------------------------------------------------------------42 Figure 10: Annual Growth of Gold Prices-----------------------------------------------------------------------------48 Figure 11: Gold as a percentage of total Assets-----------------------------------------------------------------------49 Figure 12: Above ground Stocks----------------------------------------------------------------------------------------49 Figure 13: World Gold Mining Output Vs Gold Price---------------------------------------------------------------53 Figure 14: 2008 Gold Production---------------------------------------------------------------------------------------55 Figure 15: Gold as tool to hedge against US Dollar currency------------------------------------------------------56 Figure 16: Gold reserves as the percentage of total reserves for United States----------------------------------59 Figure 17: Gold reserves as the percentage of total reserves for India---------------------------------------------59 Figure 18: Gold reserves as the percentage of total reserves for China--------------------------------------------60 Figure 19: The GDP and the savings rate of India--------------------------------------------------------------------63 Figure 20: Gold Rush-----------------------------------------------------------------------------------------------------65
List of Tables
Table 1: World Official Gold Holdings-------------------------------------------------------------------------------19 Table 2: India’s Foreign Exchange Reserves-------------------------------------------------------------------------23 Table 3: Gold Production weighted index of countries--------------------------------------------------------------30 Table 4: Gold Consumption weighted index of countries-----------------------------------------------------------30 Table 5: Salary Vs Deposits- Cross Tab-------------------------------------------------------------------------------38
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Role Of Gold In Indian Monetary System
Table 6: Chi-Square Tests------------------------------------------------------------------------------------------------39 Table 7: Emerging Market Adequacy Reserve Ratios----------------------------------------------------------------43 Table 8: Excess Reserves of Countries---------------------------------------------------------------------------------44 Table 9: Correlation of Gold prices with various other commodities----------------------------------------------45 Table 10: Top Gold Mining Companies--------------------------------------------------------------------------------54
Preface
Central banks of countries around the world, including RBI, hold 29,634 tonnes of gold, compared to an annual world gold production of roughly 2,400 tonnes. So, their gold sales, leases and purchases have a huge impact on international gold prices. China, now the world’s biggest gold producer, has increased reserves of the metal by 76 per cent.
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Role Of Gold In Indian Monetary System Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand, including hoarding and disposal. Unlike most other commodities, the hoarding and disposal plays a much bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price. Given the huge quantity of hoarded gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production. Gold is always seen as a thing to own and only for consuming as ornaments, for jewellery but seldom as an investment purpose . Gold is unlike a bond. Gold pays no interest. But, Gold cannot become worthless like a bond can. The values of both rise and fall in free market trading. With prices falling and the economy deteriorating, investors traditionally hoard cash and near-cash safe instruments such as government bonds, money market funds and gold The belief that money market funds pose zero risk and are super safe has also been badly shaken as the credit crisis has drained liquidity, prompted forced sales and knocked down the value of such funds. Stocks and Bonds prosper in strong economic times and bear higher risks in bad times. By contrast, Gold ignores recessions and does well when these and other traditional investments fail. Gold investments also acts as an anti-currency. Here at home, Gold soars in value when the U.S. Dollar is falling. Better still, Gold loves and thrives on inflation– events that Bonds hate and destroys the buying power of cash, Bank CDs, or other debt instruments.
Chapter 1: Introduction
A monetary system is anything that is accepted as a standard of value and measure of wealth in a particular region.
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Role Of Gold In Indian Monetary System The current trend, however, is to use international trade and investment to alter the policy and legislation of individual governments. The best recent example of this policy is the European Union's creation of the euro as a common currency for many of its individual states. Modern currencies are not linked to physical commodities (silver or gold) and are not a contract to deliver a good or service. As such the value of a currency fluctuates based on politics, perception and emotion in addition to monetary policy. Apart from monetary systems based on money, there do also exist systems based on "favors". One example of this is the LETS system. LETS, or Local Exchange Trading Systems, are local community trading groups where members exchange their goods and services with each other. Monetary system is one in which the standard unit of currency is a fixed quantity of gold or is kept at the value of a fixed quantity of gold. The currency is freely convertible at home or abroad into a fixed amount of gold per unit of currency. In an international gold-standard system, gold or a currency that is convertible into gold at a fixed price is used as a medium of international payments. Under such a system, exchange rates between countries are fixed; if exchange rates rise above or fall below the fixed mint rate by more than the cost of shipping gold from one country to another, large gold inflows or outflows occur until the rates return to the official level. These “trigger” prices are known as gold points. The gold standard was first put into operation in Great Britain in 1821. Prior to this time silver had been the principal world monetary metal; gold had long been used intermittently for coinage in one or another country, but never as the single reference metal, or standard, to which all other forms of money were coordinated or adjusted. The great gold discoveries in California and Australia in the 1840s and ’50s produced a temporary decline in the value of gold in terms of silver. This price change, plus the dominance of Britain in international finance, led to a widespread shift from a silver standard to a gold standard. Germany adopted gold as its standard in 1871–73, the Latin Monetary Union (France, Italy, Belgium, Switzerland) did so in 1873–74, and the Scandinavian Union (Denmark, Norway, and Sweden) and The Netherlands followed in 1875–76. By the final decades of the century, silver remained dominant only in the Far East (China, in particular). Elsewhere the gold standard reigned. (See also Free Silver Movement.) The early 20th century was the great era of the international gold standard. Gold coins circulated in most of the world; paper money, whether issued by private banks or by governments, was convertible on demand into gold coins or gold bullion at an official price (with perhaps the addition of a small fee), while bank deposits were convertible into either gold coin or paper currency that was itself convertible into gold. In a few countries a minor variant prevailed—the so-called gold exchange standard.
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Role Of Gold In Indian Monetary System
1.1 Gold Standard:
The gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold. Three distinct kinds of gold standards can be identified. The gold specie standard is the system in which the monetary unit is associated with a circulating gold coin. The gold exchange standard may involve only the circulation of silver coins, or coins made of other metals, but the authorities will have guaranteed a fixed exchange rate with another country that is on the gold standard, hence creating a de facto gold standard in that the value of the silver coins has a fixed external value in terms of gold that is independent of the inherent silver value. The gold bullion standard is a system in which gold coins do not actually circulate as such, but in which the authorities have agreed to sell gold bullion on demand at a fixed price. 1.1.1 Gold Specie Standard: A gold specie standard existed in some of the great empires of earlier times, such as in the case of the Byzantine Empire in conjunction with the gold Byzant coin. But with the ending of the Byzantine Empire, the civilized world tended to use the silver standard, such as in the case of the silver pennies that became the staple coin of Britain around the time of King Offa in the year 796 AD. The Spanish discovery of the great silver deposits at Potosi in the 16th century, led to an international silver standard in conjunction with the famous pieces of eight, which carried on in earnest until the nineteenth century. In modern times the British West Indies was one of the first regions to switch to a gold specie standard. The gold standard in the British West Indies, that followed from Queen Anne's proclamation of 1704, was based on the Spanish gold doubloon coin. In the year 1717, Sir Isaac Newton, who was master of the Royal Mint, established a new mint ratio as between silver and gold that had the effect of driving silver out of circulation and putting Britain on a gold standard. But it wasn't until the year 1821, following the introduction of the gold sovereign coin by the new Royal Mint at Tower Hill in the year 1816, that the United Kingdom was formally put on a gold specie standard. The United Kingdom was the first of the great industrial powers to switch from the silver standard to a gold specie standard. Soon to follow was Canada in 1853, Newfoundland in 1865, and the USA and Germany 'de jure' in 1873. The USA used the American Gold Eagle as their unit, and Germany introduced the new gold mark, while Canada adopted a dual system based on both the American Gold Eagle and the British Gold Sovereign. Australia and New Zealand adopted the British gold standard, as did the British West Indies, while Newfoundland was the only British Empire territory to introduce its own gold coin as a standard. Royal Mint branches were established in Sydney, New South Wales, Melbourne, Victoria, and Perth, Western Australia for the purposes of minting gold sovereigns from Australia's rich gold deposits.
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Role Of Gold In Indian Monetary System 1.1.2 The Gold Exchange Standard Towards the end of the nineteenth century some of the remaining silver standard countries began to peg their silver coin units to the gold standards of the United Kingdom or the USA. In 1898, British India pegged the silver rupee to the pound sterling at a fixed rate of 1s 4d, while in 1906, the Straits Settlements adopted a gold exchange standard against the pound sterling with the silver Straits dollar being fixed at 2s 4d. Meanwhile at the turn of the century, the Philippines pegged the silver Peso/dollar to the US dollar at 50 cents. A similar pegging at 50 cents occurred at around the same time with the silver Peso of Mexico and the silver Yen of Japan. When Siam adopted a gold exchange standard in 1908, this left only China and Hong Kong on the silver standard. 1.1.3 The Gold Bullion Standard The gold specie standard ended in the United Kingdom and the rest of the British Empire at the outbreak of the World War I. Treasury notes replaced the circulation of the gold sovereigns and gold half sovereigns. However, legally the gold specie standard was not repealed. The end of the gold standard was successfully effected by appeals to patriotism when somebody would request the Bank of England to redeem their paper money for gold specie. It was only in the year 1925 when Britain returned to the gold standard in conjunction with Australia and South Africa, that the gold specie standard was officially ended. The British act of parliament that introduced the gold bullion standard in 1925 simultaneously repealed the gold specie standard. The new gold bullion standard did not envisage any return to the circulation of gold specie coins. Instead, the law compelled the authorities to sell gold bullion on demand at a fixed price. This gold bullion standard lasted until 1931. In 1931, the United Kingdom was forced to suspend the gold bullion standard due to large outflows of gold across the Atlantic Ocean. Australia and New Zealand had already been forced off the gold standard by the same pressures connected with the Great Depression, and Canada quickly followed suit with the United Kingdom.
1.2 The Bretton Woods System
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. Preparing to rebuild the international economic system as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference. The delegates deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944.
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Role Of Gold In Indian Monetary System Setting up a system of rules, institutions, and procedures to regulate the international monetary system, the planners at Bretton Woods established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement. The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold and the ability of the IMF to bridge temporary imbalances of payments. Then, on August 15, 1971 the United States unilaterally terminated convertibility of the dollar to gold. This action created the situation whereby the United States dollar became the sole backing of currencies and a reserve currency for the member states. In the face of increasing financial strain, the system collapsed in 1971.
1.3 History of the New Monetary System
In 1913, the independent monetary system which the United States had known since its inception was replaced with the Federal Reserve System. Instead of the U.S. Treasury controlling the economy and economic needs, Americans were told that we would be "better off" if we allowed the Federal Reserve handle the economic needs of our country. Our dollars, issued by the United States Treasury, which said "Gold Certificate" or "Silver Certificate" were gradually replaced by ones that said "Federal Reserve Note." Instead of borrowing from the U.S. Treasury for any deficit shortfalls, we borrowed from this independent source, the Federal Reserve. Today, America is beholden to them to the tune of $4.7T. In addition, they control all of the monetary movements in America and the interest paid by taxpayers on the federal deficit is paid to the Federal Reserve, and not the U.S. Treasury. The assault on the purity of the composition of the dollar came on April 20, 1933 when newly-elected President Roosevelt signed the Emergency Banking Act. This legislation made it illegal for "Joe Average American" to own gold and required private citizens to turn in their gold while allowing for the countries of the world holding our currency to convert to gold at any time. With the exception of coin collectors, all American citizens who owned gold or who had Gold Certificates were required to turn their gold in exchange for paper currency issued by the Federal Reserve. In 1944, the United Nations sponsored the UN Monetary and Financial Conference, known as the "Bretton Woods" Monetary Conference as it was held in Bretton Woods, New Hampshire. There 700 delegates from 44 countries met to determine the value of money in the post-World War II era. At this conference, the United States dollar, which had the highest amount of gold reserves backing it, was named the international reserve currency of the world. What this meant was that all of world commerce would use the dollar to trade with and all other currencies would be linked to it at a fixed exchange rate, thus stabilizing the value of world currencies to the value of the dollar. In addition, participating countries could convert their dollars to
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Role Of Gold In Indian Monetary System gold at any time, if they chose to do so. (Currently there is discussion to restructure the agreements made at Bretton Woods by removing the dollar as the world's reserve currency.) From that time, until 1968, when French President Charles deGaulle requested of President Lyndon Johnson that the paper dollars he held be converted to gold, the dollar was premier, as it had plenty of gold backing it, or so everyone thought. It was President deGaulle who very astutely realized that America was monetizing their debt to finance the Vietnam War and he wanted his dollars in gold before the gold window was closed. By the time he converted in June of that year, our gold reserves had dwindled from $30B in 1944 to less than $10.5B. It was, however, President Richard M. Nixon who closed the gold window on August 13, 1971, thus changing the nature of the world monetary system forever and perhaps signaling the "countdown to a world currency." The world's monetary system was transformed from accountability, based on the amount of gold a given country had in its treasury and the amount of paper currency it was printing, to no accountability other than the good opinion of the other countries around the world. This set the stage for the eventual evolution (now currently taking place) of all the world currencies into one. When America went off gold, the rest of the world followed, so that by 1973, with the exception of Switzerland, all of the world was trading in paper. During the time when the shift happened not many countries actively participated in the currency exchange since the trade was limited between few developed countries of those time. Initially only countries countable on a single hand were involved, now the number has grown multifold. Now that the world has seen another monetary crises, just next to the great depression, everyone is willing to shift to a system with a stable currency. This was the topic of discussion in the G-8 summit held in july 09. China’s position was made clear, “To avoid the inherent deficiencies of using sovereign currencies for reserves, there's a need to create an international reserve currency that's delinked from sovereign nations," is the position of the People's Bank of China. The IMF should expand the functions of its unit of account, Special Drawing Rights it feels. The restatement of Governor Zhou Xiaochuan's proposal in March added great weight to the likelihood that China will diversify its currency reserves, the world's largest at $2.0+ now. Zhou Xiaochuan sees the current international financial system as flawed, putting too much emphasis on the $ as a reserve currency. They feel that the $ should depreciate to address the global imbalance. But if this happens and because it’s a reserve currency it would give the rest of the world a monetary crisis too! We are certain China will not wait for the West to accommodate their wishes but as you can see below will act in the short-term to adjust their own reserve policies for the benefit of China. With little cooperation from the West we can now look forward to the destabilization that attends global currency confrontation.
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Role Of Gold In Indian Monetary System China, the biggest foreign holder of U.S. government, is already in the process of cutting its $ holdings. In April it cut them by $4.4 billion to $763.5 billion in April, the first monthly reduction since February 2008 It is difficult for China to do this quickly, for such moves would cause the $ to collapse, if seen as a departure from the U.S. $ by the Chinese. The unhappiness with the $ is not limited to China. Russia holds only Euros in its reserves now, in reaction to the dangers facing the $. Internationally, by the end of 2008 the $ accounted for 64% of global central bank reserves, down from 73% in 2001, after the arrival of the € on the global monetary scene.
1.4 Dollar Problems:
The U.S. $ is being undermined by U.S. economic problems and its over-issuance by the Fed, despite comforting platitudes flowing from U.S. Monetary authorities over the last few years. The threats internal U.S. policies posed to the international monetary system are frightening. The virtually zero response from U.S. monetary authorities to international $ problems, has disturbed eastern central banks because the $ holdings in the reserves of foreigners are huge and could well be diminished in value considerably in the years to come. It is also clear that the U.S. has a great deal to gain both from a depreciating $ and from inflation, despite the impact on the U.S. economy. As a result confidence both in the U.S. economy and in the $ has dropped considerably since the credit crunch impacted in August 2007. The problem is how to get away from the $’s grip without collapsing the global monetary system itself! "The excessive reliance on the credit of several sovereign currencies has added to the risks and crises, the P.B.O.C. said adding, "A currency with stable value in the long term is required."
1.5 Actions Underway for Change
The biggest $ reserve holders are taking small and uncertain steps already:
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Role Of Gold In Indian Monetary System • Russian President Dmitry Medvedev, Chinese President Hu Jintao, Indian Prime Minister Manmohan Singh and Brazilian President Luiz Inacio Lula da Silva called for a "more diversified" monetary system to reduce dependency on the U.S. $ at a June 16th meeting. • In May, China and Brazil began studying a proposal to move away from the $ and use Yuan and Reais to settle trade instead. • Group of 20 leaders on April 2 gave approval for the IMF to raise $250 billion by issuing Special Drawing Rights, or SDRs, the artificial currency that the agency uses to settle accounts among its member nations. It also agreed to put another $500 billion into the IMF's war chest. • This month, Russia and Brazil announced plans to buy $20 billion IMF bonds, while China said it is considering purchasing $50 billion. • IMF First Deputy Managing Director John Lipsky said on June 6th “it's possible to take the "revolutionary" step of making SDRs a reserve currency over time”. The U.S. and other developed nations will attempt to drag out such moves because this disturbs the present global balance of power.
Chapter 2: Review of Literature
2.1 Factors Influencing the price of Gold
Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand, including hoarding and disposal. Unlike most other commodities, the hoarding and disposal plays a much
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Role Of Gold In Indian Monetary System bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price. Given the huge quantity of hoarded gold, compared to the annual production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production. The price of gold is set by the Gold Fixing. Also known as the Gold Fix or London Gold Fixing, this is a meeting of five members of the London Gold Pool that is conducted twice a day by telephone, at 10:30 GMT and 15:00 GMT. Officially, the purpose of the Gold Fixing is to settle contracts between members of the London bullion market. However, the Gold Fixing is widely recognized as the benchmark used to price gold and gold products throughout the world Thought to be one of the first known metals, gold has been coveted throughout history for its beauty, scarcity, malleability, and uncanny resistance to rust and corrosion. Centuries ago, gold’s unique combination of properties – its sun-like color, its soft hardness, and, especially, its imperviousness to decay and corruption – imbued it with magical associations in the eyes of many. Because of these unique properties, gold has traditionally been the currency of choice for much of the world’s population. The value of gold has transcended all national, political, and cultural borders, making it the ideal currency. Historically gold prices were determined by a combination of political and economical factors, till a universally acceptable concept of London and American gold price was institutionalized. An outcome of such initiatives was the Washington Agreement. However, in the past few years, the major factors impacting the gold price can be summarized as under:
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Weak US Dollar Growth in Demand for Jewelry Increase in demand for exchange-traded paper backed products
2.1.1 Weak US Dollar Projections about a declining dollar due to an ever-increasing twin deficit supported by many investment veterans are met by much denial from politicians as well as from investors. As long as foreigners are willing to pour in the amount of $2 billion dollars every working day, the dollar won't crash. But if foreign confidence were to wane, the US dollar will be heading south. No matter how you look at the US twin deficits and America's future fiscal liabilities, this problem is huge and some painful adjustments not only seem to be necessary but unavoidable as well. It should be obvious that one of these major painful adjustments will be a massive devaluation of the US dollar.
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Role Of Gold In Indian Monetary System Simple, the US dollar is the key driver for Gold; as the dollar goes, so will gold; but in the opposite direction. Gold is the anti-dollar with a high inverse correlation to the dollar! In the end, gold is still a monetary asset and trades like a currency. 2.1.2 Growth in Demand for Jewelry In spite of the convergence of Diamond and Palladium, the demand for gold jewelry has seen a regular growth year on year. Countries which are primarily responsible for this growth are India, China, Italy, Turkey and the USA. The demand for consumption of gold in jewelry was 6% higher at 735 tonnes and also comprised a new first-quarter record. The US, which accounts for 10 % of world gold demand, is also one of the markets where public taste in gold jewelry is enjoying a renaissance. The renewed interest in gold also extends to Japan, a market which showed a 19% increase in demand. The Indian market – the world’s largest for gold demand – was 23 % higher following the marriage and festival period which, in turn, has led to restocking by retailers. The earthquake in India, however, is unlikely to hit demand significantly as it occurred in an area which comprises only 5% of the total Indian consumption. There were sharp falls in demand in Turkey and Taiwan - down 38% and 31% respectively. This was due to economic difficulties and continued weakness in investment demand.
2.1.3 Increase in demand for exchange traded paper backed products For the first time in history, gold can be purchased like any listed stock at select stock exchanges of the world like London Stock Exchange, Australian Stock Exchange (Gold Bullion Securities) and New York Stock Exchange (Street Tracks Gold). The World Gold Council initiated Electronic Traded Funds have displayed very good performance and growth in volumes since launch. 2.1.4 Other factors leading to the variation in Gold Prices are: 1) During national crisis, such as a war or a serious natural disaster, the price of gold tends to greatly increase. People start to fear that their paper currency may no longer hold value, but they see gold as a stable asset that can always be used to purchase food and other necessities. 2) Another common factor influencing rising gold prices is the success of the real estate market. When there are low or negative returns on real estate, the demand for gold and other commodities typically is expected to increase. 3) Bank failures, although somewhat uncommon today, can also contribute to an increase in the price of gold. The best example of this occurred during the Great Depression, when rising gold prices due to bank failures led President Roosevelt to ban the holding of gold by private citizens.
2.2
Factors affecting gold prices in last three years
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Role Of Gold In Indian Monetary System If we analyze the track record of gold in the past three years, we can conclude that gold prices have seen a steady and impressive northward growth. In January 2007, gold prices per 10 gm stood at Rs 5,453. By November 2009, the price had gone up to Rs 7,005. The year 2004 has indeed been a great year for gold. There has been a substantial increase in gold prices, but this has not dampened consumers’ inclination towards investments in gold. In fact, investors have begun to recognize the effectiveness of gold as an efficient savings vehicle and an alternate asset class. Globally, the price of gold has historically been impacted primarily by the US dollar. However in the past few years, oil prices, the US dollar and the demand-supply equation for gold have become equally significant contributors to the price of gold.
2.3
Gold as investment
Demand for gold for the purpose of investment has outpaced the demand for the yellow metal for jewelry in 2009. Indians purchased 74.0 tonnes of gold for investment from January to September 2009, while it was 67.8 tonnes during the same period in 2008. While the advantages of having gold in an investor’s portfolio has been talked about time and again, ‘what should be the amount of investment’ is always a question asked by the investors. There are two schools of thought on this subject. The recommendations are in the range of a 15% to 20% allocation of the total portfolio.
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15% of the investment portfolio – European Central Bank decision at the time of establishment in 1999 based on internal studies. 20% of the investment portfolio – Based on a model done by Germmill & Hillman on 20 years data.
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Ideally however, allocation to gold from an investment perspective should be based on comprehensive financial planning. It should always be remembered that investment in physical gold must always be in the form of coins/bars and should be in addition to the jewelry held by the household. Advantages of gold in a portfolio can be explained through the following points:
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Gold has a low to negative correlation with most other asset classes. An investment portfolio with an allocation to gold improves the consistency of portfolio performance during both stable and unstable periods. The price of gold is not linked to the performance of economy, industry or companies. Gold offers the benefit of diversifying portfolio risks.
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Let us consider an example where an investor invests Rs 10,000 each in various options like equities, fixed deposit, PPF and gold in March 1999. Let us see what the returns are in each case, taking the deposit period from 1999 - 2004 into consideration. In gold, by March 2004, his investment would have fetched him Rs
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Role Of Gold In Indian Monetary System 15,063, a substantial increase. The money invested in PPF would have grown to Rs.16,025 by March 2004. A fixed deposit of the same amount would have yielded Rs 13,794 by March 2004. (Refer to the data below for varying interest rates). By March 2004, his investments in equities for the same amount would have become Rs 18,916. This is provided the investor had remained invested in the market throughout the five years, even during periods when the Sensex saw huge downward movements.
2.4
Cost efficient ways of investment in gold internationally
Owning gold has been possible over the years in the form of mutual funds or stocks of gold mining companies. However, investors have been awaiting a more cost effective platform for owning gold. The World Gold council recognized this fact and launched the following ETF gold products across the world. 2.4.1 Gold Bullion Securities For the first time in history, gold was made available at the stock exchange just like an equity share to the investors through a World Gold Council initiated ETF product called Gold Bullion Securities. Each share of Gold Bullion Securities (GBS) is equal to 1/10th of an ounce of gold and is supported by physical holding of gold in the custody of HSBC. This is the first time ever that a metal has been listed on an international Stock Exchange and can be conveniently traded or invested by institutional investors as well as individuals. GBS is listed on the London Stock Exchange and also the Australian Stock Exchange. At present GBS is the most cost efficient way of investing in gold, as a potential investor has to only pay 0.3% p.a. as management fees, which includes the cost of storage and insurance apart from the ‘brokerage’ that they have to pay to the brokers. 2.4.2 Street TRACKS Gold Shares – ETF Gold fund on NYSE The first U.S. exchange-traded fund that tracks the price of gold, called STREET TRACKS Gold Shares, was launched on the New York Stock Exchange in November 2004. This is the first ETF in the U.S. that will track a commodity. It is designed to give investors the opportunity to invest in gold without requiring actual custody of the metal, which can be expensive. The ETF is expected to attract both institutional and individual investors who are looking for a hedge against inflation and currency exchange rates, or for diversification. It is sponsored by the World Gold Council and marketed by ETF provider State Street Global Markets. Each share will represent one-tenth of an ounce of gold bullion as priced by the London Bullion Market Association. The 2.3 million shares trade under the ticker symbol "GLD."
2.5 Indian Foreign Exchange Reserves
India’s accumulation of foreign exchange reserves has been unprecedented scale in recent years. Given the cost of holding huge foreign exchange reserves, the cost of holding these reserves is also on the increase. The source of accretion to the foreign exchange reserves is mainly the capital flows and is portfolio flows
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Role Of Gold In Indian Monetary System more recently. Hence, given the cost and the volatility of the capital flows which is the main source of accretion, India needs to decide on the composition of its foreign exchange reserves. Central banks of many of the countries are considering the re-engineering of their foreign reserves. The share of gold in the total foreign exchange reserves is very high in the US and in the Europe. But, the Asian economies hold a very low proportion of their foreign exchange reserves in gold. This section analyses the trends in the accumulation and sources of accretion of Indian foreign exchange reserves from the view point of if India should increase its gold holdings. Shri. S. S. Tarapore, a former Deputy Governor of the Reserve Bank of India (RBI) and Chairman of the Committee on Fuller Capital Account Convertibility, has suggested that India should increase the share of gold in its foreign exchange reserves. He said, “Gold is unique, in the sense that it is both a commodity and a store of value. More importantly, gold invariably moves inversely with the US dollar and also rises in value when international inflation gathers momentum“ In the aftermath of Asian crisis, the Emerging Market Economies (EMEs) have started accumulating foreign exchange reserves on an unprecedented scale. As reported by the Bank for International Settlements (BIS), the EMEs have accumulated reserves at an annual rate of US $250 billion (or 3.5% of their annual combined GDP) during 2000 and 2005. This is almost five times higher than the level that was prevalent in the early 1990s. (Mohanty and Turner 2006) The accumulation, as ratio to GDP, is particularly rapid in China, Korea, India, Malaysia, Russia and Taiwan (China). The accumulation of foreign exchange reserves by the EMEs is to insure against the risks of capital volatility and to protect the monetary system from shocks like the speculative attacks by the currency traders. High foreign exchange reserves are often seen as a strength indicating the backing that a currency has. To some extent, the holding of huge foreign exchange reserves also indicates the lack of confidence on the global financial architecture. With the high foreign exchange reserves accumulation, concern mounts on the costs and benefits of holding it. Hence, the composition of assets in which these foreign exchange reserves are invested, the risks they represent, the return they yield and the risk-return trade off involved become important issues. If the reserves are held as an insurance against financial crisis, then the assets need to be highly liquid and most safe. The emphasis will not be as much on earning a high yield. But, if the reserves are far greater than what is required for withstanding financial crisis, the choice of assets for investment of these reserves will be guided by return maximization as the costs of holding huge foreign exchange reserves is also high. 2.5.1 Official Stock of Gold During the gold standard the central banks started accumulating gold. In 1870, Bank of England had a gold reserve of 161 tonnes. It rose to 248 tonnes in 1938. But, the gold holding of the other countries were even higher. US had 2293 tonnes, Russia 1233 tonnes, France 1030 tonnes, Argentina 440 tonnes, Germany 439 tonnes, Austria 378 tonnes and Italy 355 tonnes. Australia had 309 tonnes. The world’s total official gold
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Role Of Gold In Indian Monetary System reserves were estimated to be around 8000 tonnes in 1913 well above the 700 tonnes in 1870. US official gold holdings increased from 6000 tonnes in 1925 to 18000 tonnes at the end of World War II. This was about 65% of all the official stocks of gold. In the 1960s, the official gold stock was about 38000 tonnes. This was around 50% of all above ground stocks. Even during the Bretton Woods system, central banks held gold reserves because the official dollar price was fixed in gold. Gold was still at the core of the international monetary system as dollar was freely convertible into gold. But, after the Jamaica agreement IMF sold half of its gold holdings to help the poor nations and returned the other half to the members. Many countries also reduced their stock of gold. In 1978 the articles of IMF was altered forbidding the countries from pegging their currencies against gold. The stock of gold in foreign exchange reserves, as a result, has changed radically over the past three decades. Gold holdings valued at market prices fell from about 60% in 1980 to as low as 9% in 2005. (Woolridge, 2006) The policy on management of gold reserves has also undergone a change over time. Initially, the gold reserves were segregated from other reserves assets and the physical holdings of gold were left unchanged even if prices fluctuated. Since the 1970s, reserve managers gradually diversified into higher yielding and higher risk instruments. Hence, holding of gold in high proportion was considered inefficient when viewed from current yield perspective. Gold does not earn any interest other than the return that it fetches if lent. That is why many central banks decided to reduce their gold holdings. Foreign currency assets started replacing gold as the main reserve asset. According to WGC, central banks held around 18% of the above ground stocks of gold as a reserve asset in 2005. This figure has been decreasing over time. In recent years, all the newly mined gold is being absorbed by the jewellery fabrication, industries and private investment. The official sector is a net supplier of gold rather than the buyer. Between 2001 and 2005, the central banks had contributed an average of 562 tonnes to annual supply flows.
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Role Of Gold In Indian Monetary System
Source: World Gold Council athttp://www.gold.org/value/reserve_asset/gold_as/reserve_stats.html 2.5.2 Gold as a Reserve Asset The International Monetary Fund’s (IMF) Balance of Payments Manual contains the following definition of foreign exchange reserves: “Reserve assets consist of those external assets that are readily available to and controlled by monetary authorities for direct financing of payments imbalances, for indirectly regulating the magnitude of such imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for other purposes.” Archer and Halliday (1998), Nugee (2000), Williams (2003) and IMF (2004) discuss the purpose of maintaining reserves. The purposes of maintaining foreign exchange reserves
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Role Of Gold In Indian Monetary System may be viewed from (i) monetary policy perspective and (ii) financial stability perspective. (i) Monetary policy perspective: For a country that follows a fixed exchange rate regime, foreign exchange reserve has an important function. In order to keep the currency exchange rate fixed, the central bank of the country has to trade in the currency market to balance the demand and supply. This requires foreign exchange reserves. However, the need for maintaining foreign exchange by a country that follows a floating exchange rate is questioned. But, such a country also requires foreign exchange to intervene in the market if a misalignment between the real exchange rate and market rate occurs. Besides, the central bank may also feel compelled to intervene in the foreign exchange market to counter inflation that may be caused by rising import prices due to depreciation in the domestic currency. The rating agencies consider that the quantum of foreign exchange reserves kept by a country enhances the credibility of its monetary policy. Hence, a country wanting to get a good rating should keep sufficient reserves. (ii) Financial stability perspective: Reserves act as shock absorbers and soften the impact of shocks like unexpected fluctuations in the currency account, changes in access to foreign markets or natural catastrophes. The reserves could ensure a balanced currency inflows and outflows under unexpected circumstances. In general, foreign exchange reserves will ensure that the forex market is functional and in the event of any market failure, the central bank can intervene. If the foreign exchange reserve maintained by a country is considered not adequate, the investors may get speculative on the currency and affect its pricing. If the reserves are adequate the confidence in the currency will get boosted and the currency will not come under such a speculative attack by the investors. Holding of adequate foreign exchange reserves by a country ensures that sufficient funds are available to service the treasury’s foreign liabilities. Y.V. Reddy (2006) summarizes the benefits of holding foreign exchange reserves, which also the purposes for holding them: “In any country risk analysis by rating agencies and other institutions, the level of reserves generally has high weights. Moreover, it is essential to keep in view some hidden benefits which could accrue to a country holding reserves, which may, inter alia, include: maintaining confidence in monetary and exchange rate policies; enhancing the capacity to intervene in foreign exchange markets; limiting external vulnerability so as to absorb shocks during times of crisis; providing confidence to the markets that external obligations can always be met; and reducing volatility in foreign exchange markets.” (pp.2). Gold can serve all these purposes. Gold is a unique asset in the sense that it is liability to none. Gold is not a subject to any country’s economic policy. Hence, it stays unaffected by the monetary and fiscal policies of any country. World Gold Council (2001) argues that the monetary problems of the modern economy would see resurgence in the importance of gold. It can hedge the risk of inflation. Aggarwal (1992) shows that gold may be an inflation hedge in the long run but it is also characterized by significant short run price volatility. Ghosh and others (2002) prove using monthly gold price data and co-integration regression techniques that gold can be regarded as a long run inflation hedge. Mani and Vuyyuri (2004) have shown that the prices of
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Role Of Gold In Indian Monetary System gold and inflation have moved in the opposite direction from 1978-79 to 1986-87. Subsequent to this, till 1991-92 the prices have moved parallel to each other. Inflation started to fall after 1991-92, but the price of gold moved up. Between 1978-79 and 1999-2000, the prices of gold have shown an upward trend. The correlation between inflation and gold prices was -0.13658. Hence, gold can act as a store of value. Gold is highly liquid and can mobilize the necessary funds in case of emergencies. To meet the balance of payments crisis on account of oil price rise, Italy pledged gold with Bundesbank and secured a $2 billion loan. Romania also used gold as collateral to secure a loan to repay external debt in 1974. In 1991 India had to tackle a balance of payment crisis. It sold 20 tonnes of gold in Swiss market and offered 46 tonnes of gold to Bank of Japan as collateral. Russia, when encountered with financial crisis in 1998 sold off 33% of its gold reserves. In 2001, the country sold its gold holdings once again to generate funds to tackle the series of natural disasters that had befallen on the country. In the aftermath of 1997 Asian financial crisis, Malaysia, South Korea and Thailand appealed to their residents to lend their gold against local government bonds to facilitate the countries to reduce their debt. This helped to stabilize their currencies. Alan Greenspan said in 1999, “…. gold still represents the ultimate form of payment in the world. It’s interesting that Germany could buy materials during the war only with gold. In extremis fiat money is accepted by nobody and gold is always accepted and is the ultimate means of payment and is perceived to be an element of stability in the currency and is the ultimate value of the currency. And that historically has always been why governments hold gold.” (Remarks by Alan Greenspan to US Congress in 1999) 2.5.3 India’s reserves’ position and movement since Independence The Reserve Bank of India (RBI) is the custodian and the manager of foreign exchange reserves of the country. This is provided for in the Reserve Bank of India Act, 1934. The preamble of the act defines the objective of the reserve management in India as, “…. keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.” Accretion to foreign exchange reserves arise out of purchases by the RBI from Authorized Dealers and from the income on foreign exchange assets deployed. Government aid receipts also add to the foreign exchange reserves. Although both US dollar and Euro are the intervention currencies, the foreign exchange reserves are denominated and expressed only in the US dollar. India’s foreign exchange reserves have been steadily increasing since 1991. The foreign exchange reserves were US $5.8 billion as at the end of March 1991. Reserves increased to US $ 25.2 billion by March 1995. At the time of Asian financial crisis in December 1997 it was US $27.355 billion. It further rose to US $38.0 billion by March 2000. The foreign exchange reserves at the end of every year from March 2003 to March 2005 were US $76.1 billion, US $113.0 billion and US $141.5 billion respectively. The figure as at the end of March 2006 stood at US $151.6 billion. The chart below illustrates the growth of foreign exchange reserves of this country from 1991 to 2006. It can be
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Role Of Gold In Indian Monetary System seen from the chart that Indian foreign exchange reserves have been registering a steady growth and it is more rapid in the recent years. It should be noted here that the foreign exchange reserves data prior to 200203 do not include the Reserve Tranche Position in IMF.
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2.5.4 India’s Accumulation of Foreign Exchange Reserves India was a closed economy till 1991. The opening up of Indian economy happened in the wake of a balance of payments crisis it encountered in 1991. Current account was in surplus for most years until 1980. India’s economic policies were emphasizing import substitution rather than export led growth. But, from the beginning of 1980s the current account started showing a deficit. During the first half of the 1980s, the current account deficit stayed well below 2% of GDP. In the second half of 1980s, current account deficit widened because of oil price hike. Prior to
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Role Of Gold In Indian Monetary System 1991, capital flows to India predominantly consisted of aid flows, commercial borrowings and non-resident Indian deposits. (Chopra and others 1995) India’s external debt was at US $69 billion by the end of 1990-91. Medium and long-term commercial debt stood at US $10.5 billion. Short-term external debt grew sharply to US $6 billion. The ratio of debt-service payments to current receipts was as big as 30%. India’s balance of payments also suffered from capital account problems due to erosion of investor confidence. India’s foreign exchange reserves were US $ 5.8 billion at the end of March 1991. It further depleted to US $975 million on July 12, 1991. It was barely enough to pay for a week’s imports. The country had to sell 20 tonnes of gold in Swiss market to raise finance. It shipped another 46 tonnes of gold to London to offer as collateral for a loan of about US $415 million from Bank of Japan, as a adhoc measure before a loan could be arranged with International Monetary Fund (IMF). This forced the country to initiate liberalization of economic policies that led to opening up of the domestic markets to international investors. Its current account was opened up only in August 1994. The capital account is being gradually liberalized. As a result, the foreign exchange reserves which stood at US $5.8 billion as at the end of March 1991 registered a phenomenal increase. It was at US $151.6 billion at the end of March 2006. 2.5.5 Sources of Accretion to Foreign Exchange Reserves The main source of accretion to foreign exchange reserves during the period 1991-92 to 2005-06 is the capital account surplus. The increase in foreign exchange reserves is caused by an increase in the annual quantum of foreign direct investment from US $129 million in 1991-92 to US $57.7 billion in 2004-05 and future to US $7.2 billion in 2005- 06. The outstanding NRI deposits grew from US $13.7 billion at the end of March 1991 to US $35.2 billion at the end of March 2006. Foreign Institutional Investors (FIIs) are allowed to make portfolio investments in India since 1993. The cumulative FIIs investments increased substantially from US $827 million in December 1993 to US $45.3 billion in March 2006. India’s exports, which stood at US $17.9 billion in 1991-92, rose to US $100.7 billion in 2005-06. Net invisible inflows grew from US $1.6 billion to US $40.9 billion in 2005-06. India’s current account was in deficit at 3.1% of GDP in 1990- 91. It turned into a surplus of 0.7% in 2002-03. A surplus in the invisibles account helped to post a surplus in the current account to the tune of US $14.1 billion in 2003-04. However, this could not be sustained. In 2004-04, the current account registered a deficit of US $5.4 billion. The deficit continued in 2005-06 and was at US $10.6 billion. 2.5.6 Components of Indian Foreign Exchange Reserves The three components of the foreign exchange reserves of India are Gold, Special Drawing Rights (SDRs), and Foreign Currency assets (FCAs). The RBI Act permits investment of foreign exchange reserves only in the following categories: (i) Deposits with other central banks and the Bank for International Settlements. (BIS). (ii) Deposits with foreign commercial banks.
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Role Of Gold In Indian Monetary System (iii) Debt instruments representing sovereign/sovereign-guaranteed liability with residual maturity not exceeding 10 years. Other instruments/institutions as approved by the Central Board of Directors of the central bank. The following table gives the investment of Indian foreign exchange reserves. It can be noticed from the table that the country has increased its investment in foreign currency assets over time with the increases in the level of foreign exchange assets. This is very much in line with the global trend. From the 1970s, monetary authorities have gradually shifted out of gold. They started reallocating their reserves to foreign currency assets that offer more attractive risk adjusted returns. Bank deposits have gained importance in recent years. Wooldridge (2006) says, “Monetary authorities have since the 1970s gradually diversified into higher-yielding, high-risk instruments. Nevertheless, official reserves are still invested mostly in very liquid assets, with limited credit risk. After falling markedly, the proportion invested in bank deposits has increased slightly in recent years. This is mainly because of the rapid accumulation of reserves by developing countries, which tend to place a larger share of their reserves with banks than do industrial countries”. (pp.31) As at the end of March 2006, of the US $145108 million invested in the foreign currency assets, US $109936 was kept as deposits with other central banks, BIS and foreign commercial banks. This was the case in March 2005 as well. Of the US $135571 million invested in foreign currency assets, US $98752 million were held as deposits. The increase in the value of gold holdings is because of the increase in the global prices of gold rather than from fresh investment. The table of India’s foreign exchange reserves gives the physical holding of gold. It can be seen that the physical holding of gold has not changed at all over March 2000 to March 2006. But, the share of gold in the foreign exchange reserves as come down as US $ 112928 millions were added to the reserves during this period. As at the end of 1990 India had 333 tonnes of gold. It increased to 398 tonnes at the end of 1995 partially due to the acquisition of confiscated gold. The physical holding of gold reduced by about 39 tonnes and the stock stood at 358 tonnes in 1998. This is due to the repayment on maturity of gold backed bonds issued in 1993. Since then the stock of gold has remained unaltered.
2.6 Gold Market Report by Data Monitor
2.6.1 Research Highlights The global gold market generated total revenues of $67.2 billion in 2008, representing a compound annual growth rate (CAGR) of 20.3% for the period spanning 2004-2008. Market production volumes experienced fluctuations in growth between 2004-2008, posting both negative and positive growth rates and declining slightly overall from its 2004 level, to reach a total of 2,434.6 metric tonnes in 2008. The performance of the
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Role Of Gold In Indian Monetary System market is forecast to decelerate, with an anticipated CAGR of 2.3% for the five-year period 2008-2013, which is expected to drive the market to a value of $75.2 billion by the end of 2013. 2.6.2 Market Analysis The global gold market has posted strong, double-digit growth rates over 2004-2008 period. The market is forecast to grow in value towards 2012; however at a significantly lower rate. The global gold market generated total revenues of $67.2 billion in 2008, representing a compound annual growth rate (CAGR) of 20.3% for the period spanning 2004-2008. In comparison, the European and Asia-Pacific markets reached respective values of $8 billion and $21 billion in 2008. Market production volumes experienced fluctuations in growth between 2004-2008, posting both negative and positive growth rates and declining slightly overall from its 2004 level, to reach a total of 2,434.6 metric tonnes in 2008. The market's volume is expected to rise slightly to 2,436.9 metric tonnes by the end of 2013, representing a CAGR of less than 0.1% for the 2008-2013 period. The performance of the market is forecast to decelerate, with an anticipated CAGR of 2.3% for the five-year period 2008-2013, which is expected to drive the market to a value of $75.2 billion by the end of 2013. FIGURE 1: Global Gold Market Value
2.6.3 Portfolio diversification Asset allocation is an important aspect of any investment strategy. By balancing asset classes of different correlations, investors hope to maximize returns and minimize risk. However, while many investors may believe that their portfolios are adequately diversified, they typically contain only three asset classes stocks, bonds and cash.
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Role Of Gold In Indian Monetary System To counter adverse movements in a particular asset or asset class, many investors now strive to achieve more effective diversification in their portfolios by incorporating alternative investments such as commodities. While gold has shown strong returns over recent years, its most valuable contribution to a portfolio lies in the fact that it is not correlated with most other assets, as shown in the chart below. This is because the gold price is not driven by the same factors that drive the performance of other assets. FIGURE 2: 5-Year Correlation of Weekly returns
The sources of demand for gold are far more diverse - both geographically and sectorally - than those for many other assets, which helps to explain the independence of the gold price as well as why identifiable demand has remained robust in the face of a rally that has spanned several years. The value of gold demand increased by 219% between 2001 and 2008. Moreover, most spending on gold is discretionary. 68% of total identifiable demand over the five years to December 2008 came from the jewellery sector, with a further 20% from investment and 12% from industrial demand. This is unusual for commodities, where demand is typically driven by non-discretionary spending and is consequently more exposed to the vagaries of the economic cycle. The recent growth in investment demand, at both the institutional and retail level, with a 141% increase in tonnage demand over the last five years (to year-end 2008), has further broadened the demand base for gold, and this can act as a counterbalance when recessionary pressures may dampen consumer demand for jewellery. Gold offers enhanced diversification opportunities relative to many alternative assets. Independent studies have shown that while alternative assets and traditional diversifiers often fail during times of market stress or instability, even a small allocation to gold may significantly improve the consistency of portfolio performance during both stable and unstable financial periods.
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Role Of Gold In Indian Monetary System 2.6.4 Gold and the dollar Gold has long been regarded by investors as a good protection against depreciation in a currency's value, both internally (i.e. against inflation) and externally (against other currencies). In the latter case, gold is widely considered to be a particularly effective hedge against fluctuations in the US dollar, the world's main trading currency. FIGURE 3: Gold and the trade-weighted Dollar
2.6.5 Consumption and Production of gold across countries Globally, gold production and consumption predominantly occurs in countries whose currencies are not tied to the US dollar. Price changes when measured in the currencies of these gold producing and consuming countries, and deflated by local inflation, provide an important indication of the price factors underlying trends in gold production and consumption. As an exercise to highlight these price developments, since 1999 GFMS has published in the annual Gold Survey production and consumption weighted price indices. The production weighted price index is based on gold prices, measured in domestic currencies, for the Top 10 gold producing countries in 2001 (these countries account for around 75% of annual world mine production). Individual country indices of the gold price, expressed in each country’s national currency, and deflated by that country’s CPI (Consumer Price Inflation) are constructed. A weighted aggregate index is then calculated from these indices. The weights are obtained by taking each country’s share in the Top 10’s mine production for each year. For 2001, these weights are as follows:
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Role Of Gold In Indian Monetary System TABLE 3: Gold Production weighted index of countries
Source: GFMS (Gold Field Mineral Services)
The consumption weighted price index is constructed is a similar manner. This index utilizes data from the Top 19 jewellery consuming countries in 2001, which account for around 75% of annual global jewellery demand. The countries and associated weights in 2001 are shown below. TABLE 4: Gold Consumption weighted index of countries
Source: GFMS (Gold Field Mineral Services)
The Figure overleaf illustrates the evolution of the production and consumption weighted price indices from January 1994, alongside the US dollar gold price index (deflated by US CPI). Between 1994 and 1997, all three indices move in a broadly similar manner, indicating that exchange rates and inflation in the United States and producing and consuming countries followed comparable trends. However from 1998 the production index begins to diverge, rising strongly above both the US dollar and consumption weighted indices, and illustrating weakening real exchange rates in key producing countries. Moreover from January 2000, the consumption index also moves above the US dollar index, again showing a real strengthening of the dollar.
FIGURE 4: Production and Consumption Weighted Real Gold Price
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Source: GFMS (GOLD FIELD MINERAL SERVICES)
Over the period 1994-2001, global mine production increased by 14%, with rises in Indonesia, Peru and China (amongst others) outweighing a large (33%) fall in production from South Africa. Rather paradoxically, South Africa experienced the largest rise in the real domestic price whilst recording the greatest drop in production. This reflects the mature nature of the South African gold mining industry lower grades, an aging infrastructure and industry consolidation have all contributed to the decline in South African mine production. That this occurred against the background of a 39% increase in the real domestic gold price begs the question: what would production have done had local prices followed the 33% fall in the real US dollar price? Undoubtedly, the decline in production would have been more marked as industry consolidation would have accelerated and marginal shaft sections closed earlier. The situation in Canada, which experienced a 17% fall in the real local price against the 33% fall in the US dollar price, is similar to that of South Africa. Canadian mine production has been more robust than that of South Africa, increasing by 8% between 1994 and 2001. However, in recent years, small mines have been closing and production has fallen by 8% since 1997. Undoubtedly, the pace of these closures would have been greater had local prices fallen as much as the US dollar price. By contrast, GFMS estimate that production in Peru and Indonesia, which experienced a 22% fall and 7% rise in the domestic prices respectively, is less sensitive to price developments. Developments in Peru have been linked to mining laws encouraging foreign investment, whilst Indonesian production is dominated by production at Grasberg, where gold output is a by-product of copper production. Australia experienced an 11% increase in mine production between 1994 and 2001, although since 1998 production has been on a downward trend. Real local prices fell by 16% over the January 1994-June 2002
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Role Of Gold In Indian Monetary System period, but have increased by 15% since 1998. GFMS believe that the recent fall in Australian mine production is less related to domestic price developments than ore depletion at a number of historically important operations. Turning to consumption, the story is equally divergent. Jewellery consumption between 1994 and 2001 increased by 14%. Major changes occurred in India and the Middle East on the positive side, and China on the negative side. Indian jewellery consumption increased by 289 tonnes (89%) whilst combined consumption in the UAE, Saudi Arabia, Iran and Egypt rose by 138 tonnes (51%). These are the typical price sensitive regions. Indian real prices actually declined by 37% between 1994 and 2001 (against the 33% fall in the dollar price) suggesting that domestic inflation (leading to a strengthening of the rupee in real terms) may have bolstered demand, whilst in the Middle East, with the exception on Iran, real prices fell by less than the dollar price, a factor that may have tempered offtake. The situation in China is an interesting case, although real prices fell by 41%, consumption dropped by close to 40%. This reflects the fact that the Chinese market has been experiencing a secular downward trend. Although the sensitivity of both global demand and supply to changes in local prices is difficult to gauge, weakness in producer currencies over the last six years has undoubtedly acted to boost supply above the level that would have occurred with stable real exchange rates. The situation for demand may be less clearcut largely as weakness in consuming countries’ currencies has been less pronounced. The extension of these arguments is that in the absence of real weakness in producer currencies, global mine supply between 1995 and 2001 would have been lower, and US dollar prices therefore probably higher. 2.6.6 Consumption of gold across BRIC nations: India is by far the largest buyer of gold among the BRICs, now accounting for 15% of total world demand. But India’s consumption is actually below its peak in 2001—in both volume and percentage terms despite expectations that the economic boom there would spark higher consumption. This may reflect financial liberalization, which is undermining one of the traditional drivers of Indian gold consumption.
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2.7 Future of gold investments in India:
Despite the global slowdown, weaker dollar value and reduced physical offtake, total consumption of gold in India may remain static to around 800-850 tonnes for the calendar year 2009, from 900 tonnes last year, thanks to sustained rural buying and retail investment demand, trade sources said. Traders expect total imports of gold to remain around 475-500 tonnes during the year. In 2008, the country imported total 712.6 tonnes of gold, according to World Gold Council (WGC). Of which, 500 tonnes of gold was for Jewellery making and 211 tonnes for investment purposes. In 2009, the country may import less gold but the consumption for gold jewellery and investment purposes would remain steady, Agri-commodity Consultant, Dhimant Bhatt said. “I believe total imports would reach to round 500 tonnes this calendar year though higher prices have gone up to record levels recently. Standard gold prices in the domestic market hovered around Rs16,800 per 10 gram, an all time high levels,” Bullion Analyst, Bhargav Vaidya said. Average price of gold in 2009 so far has increased by 21% to Rs15,105 per 10 gram from average Rs12,500 per 10 gram in the full year 2008. “The gold market become more vibrant and I would like to add that price gap between landing cost of imported gold and market price has reduced to almost zero levels and there is no disparity in the market due to availability of online spot trading platform for gold trading,” RiddiSiddhi Bullions managing director, Prithviraj Kothari said. It can be noted that gold prices jumped up by nearly 1.5 times from average Rs5,850 in 2004 to Rs15,105 per 10 gram over past five years on increasing demand for investment purpose. It is considered as a hedge against inflation. COMEX gold futures for December delivery traded near $1,120 an ounce last week after rallying to a fresh record of $1,122.20 an ounce in the previous session. A weak US dollar and general flat currency fear across the globe shot up the gold price to new highs.
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2.8 Gold and the international monetary system – a chronology
1717 In UK Sir Isaac Newton (Master of the Mint) gives guinea statutory valuation of 21sh (shillings). Mint price of gold 77sh 10½d per standard ounce. UK Gold Standard commences. Napoleonic Wars. Bank of England suspends gold payments. UK Coinage Act (Post-Napoleonic Wars). Sovereign the standard unit @ one standard ounce of gold (>11/12 fine) = 77sh 10½d. Bank of England obliged to buy gold @ 77sh 9d. All major countries, other than China, switch to the gold standard, linking their currencies to gold. Bimetallism is abandoned. Federal Reserve Act establishes US system of reserve banks. At least 40% of note issue to be backed by gold. US prohibits gold exports. UK prohibits gold exports without official permission. UK now off Gold Standard. US gold exports permitted again. London Gold Fixing established. 1925 UK returns to Gold Standard at pre-War parity of $4.86=£1 UK Gold Standard Act. Currency convertible @ 77sh 10½d per standard ounce. But only in amounts of 400 oz. Export of gold again permitted. 1931 1933 UK abandons Gold Standard. US convertibility suspended (with gold @ $20.67/oz). Export, all transactions and holding of gold forbidden. Presidential Proclamation makes dollar again convertible to gold (at new price of $35/oz) Tripartite Agreement. US, UK and France willing to buy and sell gold freely with each other in exchange for own currency. London gold market closed on outbreak of war. Bretton Woods Conference sets basis of post-war monetary system. US dollar to maintain $35=1 oz gold conversion rate. Other currencies to be fixed (but adjustable) in terms of US dollar, thus forming a Gold Exchange Standard.
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1797 1816
1844 18701900 1913
1917 1919
1934 1936
1939 1944
Role Of Gold In Indian Monetary System 1945 IMF Articles of Agreement effective. Par values established for all members based on gold value of US dollar on 1 July 1944 (0.888671 grammes of fine gold). London gold market re-opens after World War 2. Gold Pool established (members Belgium, France, Germany, Italy, Netherlands, Switzerland, UK and Federal Reserve Bank of New York: France withdrew in June 1967). Members would sell (and later buy) gold in the London market to maintain prices close to par in that market. Sterling devalued from $2.80 to $2.40. This leads to pressure on the dollar and hence to substantial buying of gold. London market closed at request of US government. Gold Pool abolished and 2-tier market created. Central banks transact only among themselves at official price and neither buy nor sell from London or any other market. Private sector, however, free to do what it likes, with floating gold price. London market re-opens 1 April and now fixing in US$ for first time. First amendment to IMF articles agreed. A new reserve asset, the Special Drawing Right (SDR) was created and given the value of 0.888571 gram of fine gold, the same value as the US dollar in July 1944. 1971 US$ convertibility to gold suspended. Smithsonian Agreement on new exchange rates. 1972 1973 US$ devalues to $38/fine oz. US proposes further devaluation to $42.22/fine oz. Major central banks suspend dealing in foreign exchange markets. Most major countries adopt floating exchange rate regime. US devaluation effective. 2-tier gold market formally abandoned. 1975 US abolishes restrictions on citizens buying, selling or owning gold (formerly needed Treasury licence). First US gold auction (2 million oz auctioned; less than half bid for). Second US gold auction (½ million oz).
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1954 1961
1967
1968
Role Of Gold In Indian Monetary System Group of 10 major industrial countries and Switzerland agree that there would be no attempt to peg price of gold and that total stock held by the IMF and the monetary authorities of the G10 countries would not be increased. IMF’s Interim Committee agrees to disposal of 50 mn oz (one third) of Fund’s gold. 25 mn oz to be sold and surplus devoted to a Trust Fund which would extend concessional loans to lowincome members and the other 25 mn oz to be restituted to members at the official price. 1976 1978 First IMF gold auction. 2nd Amendment to IMF Articles of Agreement comes into effect. Gold’s formal role in international monetary system disappears. US gold auctions resume. 1979 European Monetary System established. Those participating in its exchange rate arrangements must - and other members can - swap 20% of gold and US$ reserves on rolling quarterly basis with European Monetary Cooperation Fund for ECU Final US gold auction. During the two phases (1975; 1978/79) some 530 tonnes (17 mn oz) were sold. 1980 Last of 45 IMF gold auctions. 25 mn oz (= 778 tonnes) were sold in all at average price of $240 (lowest/highest prices $109/$712). US Gold Commission reports to Congress. Official holdings of 264 mn oz should certainly not be reduced to zero and a minority favoured no reduction at all. Plaza Agreement on currencies. Louvre Accord on currencies. Treaty on European Union signed at Maastricht. This includes agreement for qualifying countries to proceed to Economic and Monetary Union (EMU - the single currency) on a default date of January 1999. Provision is made for the mutation of national central banks into the European System of Central Banks (ESCB) headed by the European Central Bank (ECB). The ECB will be able to call an initial amount of Ecu50bn (Euro 50bn) of gold and foreign reserve assets from participating countries. Reserve management of all ECSB banks, including that of gold holdings, will be subject to guidelines to be issued by the ECB council. Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain confirmed as participants in EMU, scheduled to start in January 1999. The Governing Council of the European Central Bank decides that 15% of its initial reserves of 39.5bn Euro, due to be transferred to it on the first day of 1999, will consist of gold. The Council also agrees that before the end of the year it will adopt an ECB guideline which will subject all
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1982
1985 1987 1992
1998
1998
Role Of Gold In Indian Monetary System operations in foreign reserve assets remaining with the national central banks, including gold, to approval by the ECB. 1998 The swaps of 20% of their gold and US$ reserves deposited with the European Monetary Institute (formerly the European Monetary Cooperation Fund) by EU national central banks in return for Ecu are unwound. European Monetary Union starts. The eleven founding members transfer a total of 39.6bn euro of gold and foreign exchange reserves to the European Central Bank. 15% of this is gold. Central Bank Gold Agreement (CBGA) announced. Under this 15 European central banks (the European Central Bank, the eleven members of European Monetary Union, Sweden, Switzerland and the UK) declare that gold will remain an important element of global monetary reserves, that they will collectively cap their gold sales at around 400 tonnes per year over the next five years and that they will not expand their gold leasings and their use of gold futures and options over this period. See the section on Central bank agreements on Gold for more details. Second Central Bank Gold Agreement announced. The CBGA was renewed for a further five years from September 27 2004 to September 26 1999 with an annual limit to sales of 500 tonnes. See Central bank agreements on Gold for further details and its differences from the first Agreement.
1999
1999
2004
Chapter 3: Research Methodology
To understand the role played by gold in the new Indian monetary system, it is very important to first understand what the monetary system is and its evolution as a system over the past few decades. Gold has
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Role Of Gold In Indian Monetary System been around for centuries and has always been a vital part of not only Indian monetary system but also the Global monetary system. Gold's effect on the monetary system is multi-pronged and can be studied in details when the roles are sub-divided into smaller, well-defined roles. This research tries to analyse in this manner. After conducting an exploratory research through a series of Focus Group Discussions and Depth Interviews and also with the help of secondary data available, the primary objective of the research has been branched into five secondary objectives wherein the fulfillment of these secondary objectives will in its place will fulfill the primary objective of the research.
3.1 Research Objective
3.1.1 Primary Research Objective (PRO) The objective of this research report is to present its readers the role of gold in the new Indian monetary system. 3.1.2 Secondary Research Objectives (SRO) ? To determine the significance of gold as a tool in the global market system.
? To determine the contribution of Gold in India’s exchange reserves. ? To determine the major factors influencing the price of Gold. ? To determine the significance of Gold as an investment as compared to other investment
opportunities.
? To determine the consumption pattern of Gold in India.
3.2 Tools Used
1) Daily newspapers to keep track of new developments 2) Magazines and journals to gain a deeper understanding of specific topics with relation to Gold and opinion of experts who are in a similar domain 3) Online websites to access different information and access other similar research work, if any 4) Interview with faculties from finance to understand their perspective and insights related to Gold.
3.3 Sample
We developed a questionnaire (see the annexure) based on which, questions were asked to the working professionals & faculty of SCMHRD. The questions were abstract and indirect in nature and mode of communication was primarily a face-to face interview. 50 responses were filled to analyze the importance of Gold as investment.
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Role Of Gold In Indian Monetary System
3.4 Research Methodology:
Data was analyzed using cross tabs & Chi-Square in SPSS software. Table 5: Salary v/s Gold Deposits
Crosstab Count golddeposits .00 salary less than 120000 between 120000 to 250000 Between 250000 to 500000 between 500000 to 1000000 more than 1000000 Total 9 6 4 2 2 23 1.00 1 4 6 8 8 27 Total 10 10 10 10 10 50
TABLE 6: Chi-Square Tests
Chi-Square Tests Asymp. Sig. (2Value Pearson Chi-Square Likelihood Ratio Linear-by-Linear Association N of Valid Cases a. 14.171a 15.556 12.783 50 df 4 4 1 sided) .007 .004 .000
5 cells (50.0%) have expected count less than 5. The minimum expected count is 4.60.
FIGURE 6: Bar Chart- Gold Deposits of different Income Levels
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Role Of Gold In Indian Monetary System
Findings:
The p-value is 0.007. With 90 percent confidence level, we can say that as salary increases, the investment in Gold increases.
Figure 7:Forms of investment in Gold
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Role Of Gold In Indian Monetary System Conclusion: Though the world is moving towards development, new avenues of investment in gold like Gold ETFs have been introduced. But still in India, people wish to invest in Gold in the form of jewellery. The main reason of it is the lack of awareness & knowledge about Gold ETFs. Ease of investing in jewellery also makes it a preferable option. In Gold ETFs, gold is traded in the form of securities on stock exchanges. Unlike derivative products, the securities are 100% backed by physical gold held mainly in allocated form. These securities have had a major impact on the gold market, representing an annual average of 32% of identifiable investment and 6.5% of total physical demand over the 5 years to 2008. Still it is a long way to go, before Gold ETFs could become the most preferred instrument for investment in Gold.
Chapter 4: Analysis & Interpretation
Our analysis has shown that gold has been a terrible asset class had one invested at its last peak back in January 1980. The return that an investor would have got was just 44% as compared to a similar investment in S&P 500 with dividends reinvested, which would have yielded 2,100%! Hence, it is important that one invests in gold at the right time. And how does one ascertain what is the right time? The analysis done on the past data has shown that whenever the real interest rates have been negative, gold has proved to be a very good investment. Real interest rates (interest on a risk free government bond minus the inflation rate) were negative in the US between 1973 and 1980 and gold returned 32% per annum! Similarly, the median rate of interest has been negative since 2002 and today, a period where gold has returned nearly 19% on a compounded basis. Also, stocks turn out to be a bad investment if gold soars and vice versa. Please remember that this is the US market that we are talking about and things could be different in India. Any idea what will gold do in 2010?
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Role Of Gold In Indian Monetary System Well, it looks highly unlikely that US Fed will raise interest rates significantly. In other words, real interest rates are likely to remain in the negative zone, thus clearing the field for gold to go even higher. FIGURE 8: Gold gives best Return When?
The detailed analysis makes me believe that return to the gold standard represents the best possible situation. Investors around the world are losing faith in the dollar and the problem lies with its management. The dollar is a glorious old brand that's looking more and more like General Motors.
4.1 Gold and inflation
The value of gold, in terms of the real goods and services that it can buy, has remained largely stable for many years. In 1900, the gold price was $20.67/oz, which equates to about $503/oz in today's prices. In the five years to end-December 2008, the price of gold averaged around $606. So the real price of gold has endured a century characterized by sweeping change and repeated geo-political shocks and more than retained its purchasing power. In contrast, the real value of most currencies has generally declined. FIGURE 9: Currencies in terms of Gold
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Investors in gold can point to a growing body of research supporting gold's reputation as a protector of wealth against the ravages of inflation. Market cycles come and go, but extensive research from a range of economists has demonstrated that, over the long term, through both inflationary and deflationary periods, gold has consistently maintained its purchasing power. In the short run, experience has shown that gold can deviate from its long-run inflation-hedge price, and, when enjoying a sustained buoyant period, as is currently the case, can offer opportunities for impressive returns.
4.2 Adequacy of Foreign Exchange Reserves
Traditionally, the adequacy of foreign exchange reserves was measured by the import cover. About three to four months of import cover was considered adequate. However, the South East Asian Crisis questioned the validity of this measure. The crisis lasted for a long period and a few months import cover was insufficient to absorb the external shock. In addition, the integration of global financial markets has facilitated a free flow of capital across the geographical boundaries of the countries. This has created a need for fresh measures of foreign exchange reserves adequacy. The measure needs to take into account a number of parameters like size, composition and risk profiles of various types of capital flows. It also needs to consider the various types of external shocks that a country is exposed to. Aizenman and Marion (2003) argue that reserve holdings in the period 1980 to 1996 could be explained by ‘traditional factors’, but had become significantly underestimated since the Asian crisis. The High Level Committee on Balance of Payments chaired by Dr. C. Rangarajan had suggested that payment obligations should be considered while determining the reserves adequacy in addition to import cover. Money-based and debt-based indicators were recommended in addition to trade-based indicators by the Report on Committee on Capital Account Convertibility. Invariably multiple indicators are to be used to assess the adequacy of reserves. Y.V.Reddy
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Role Of Gold In Indian Monetary System (2006) rightly summarizes: “Thus, while the traditional indicators of adequacy of reserves are based on trade, debt and monetary indicators, or even the ‘Guidotti Rule’ or ‘Liquidity at Risk’ Rule suggested by Alan Greenspan may help explain the adequacy of reserves, they need to be supplemented with, what may be described as, multiple indicators to assess the adequacy of reserves of any country at a given juncture.” (p.1) The import covers of reserves, the traditional trade-based indicator of reserve adequacy, was at the lowest at 3 weeks in December 1990. This improved to 11.5 months of import in March 2002, only to rise further to 14.2 months in March 2003. The import cover of reserves stood at 17.0 months at the end of March 2004. Subsequently, it declined to 14.3 months in March 2005 and further to 11.6 months in March 2006. The ratio of short-term debt to foreign exchange reserves declined from 146.5% at the end of March 1991 to 5.3% at the end of March 2005 and to 7.0% at the end of March 2006. The ratio of volatile capital flows (which includes cumulative portfolio inflows and shortterm debt) to reserves dropped from 146.6% as at end-March 1991 to 35.2% as at end- March 2004. The ratio registered a moderate increase and stood at 36.6% at the end of March 2005. It was at 43.2% at the end of March 2006. Three to four months import cover is considered fairly adequate. Rodrik and Velasco (1999) and Garcia Soto (2004) argue that typically a country is considered prudent if it holds foreign currency reserves in the amount of its total external debt maturing within one year. IMF (2003) also suggests that a ratio of reserves to short-term foreign debt much above one does not further reduce the risk of a crisis. India seems to hold foreign exchange reserves very much in excess of what is suggested as adequate by these measures. India is not alone in the crowd of countries that hold excess reserves.
TABLE 7: Emerging Market Adequacy Reserve Ratios
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TABLE 8: Excess Reserves of Countries
Summers (2006) argues that the wealth tied up in reserves, if invested either domestically in infrastructure or in a fully diversified portfolio in the global capital markets for a longterm, can fetch 6%. The resulting gain could be estimated to be around US $100 billion a year. The opportunity cost of the aggregate reserves of the 10 leading holders of excess reserves works out to 1.85% of their combined GDP. He says if India were
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Role Of Gold In Indian Monetary System to invest the foreign exchange reserves in global capital markets, the extra returns that would result could be between 1 and 1-1/2% of GDP each year. If annualized and valued as a stock, it is around 40% of the market value of all the traded stocks on the Bombay stock exchange.
4.3. India’s Concerns in Managing Foreign Exchange Reserves
India is faced with a current account deficit unlike many other emerging economies. The current account deficit has increased from US $5.4 billion in 2004-05 to US $10.6 billion in 2005-06. As a proportion to GDP this is an increase from 0.8% to 1.3%. This is an indication of growing openness and integration of the Indian economy with the global economy. The ratio of current receipts to GDP grew increased from 22.0% in 2004-05 to 24.5% in 2005-06. Similarly, trade openness measured as the ratio of merchandise exports and imports to GDP increased from 28.9% during 2004-05 to 32.7% in 2005-06. (RBI Annual Report, 2005-06) With the growth of domestic industry and higher oil prices in the international markets this current account deficit may be expected to widen in the coming years. This will require more foreign exchange reserves to manage the foreign exchange demand that will arise from current account transactions. As mentioned earlier, the major source of accretion to foreign exchange reserves in India is portfolio capital flows. Foreign investment flows into India comprises of Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). The cumulative foreign investment flows which were very negligible in 1990-91 registered a huge rise and were at US $106 billion in 2005-06. The share of FDI was US $49 billion and that of FPI was US $57 billion. From 1993-94 to 1997-98, the FDI flows exceeded the FPI flows. But, subsequently the trend had reversed. The rise in FPI flows had been particularly sharp since 2003-04. During 2003-04, their share of total foreign investment inflows was at 79.4%. It stood at 68.2% in 2005-06. FPI flows are considered less stable than FDI flows. Hence, with the expansion of FPI flows, an increasing level of foreign exchange reserves is required to be kept liquid to ward off any sudden shocks of capital flight. RBI’s approach to reserves management is summarized in the RBI Annual Report, 2006 as follows: “ The overall approach to the management of India’s foreign exchange reserves takes into account the changing composition of the balance of payments and endeavors to reflect the ‘liquidity risks’ associated with different types of flows and other requirements. The objectives of reserve management in India are preservation of longterm value of the reserves in terms of purchasing power and the need to minimize risk and volatility in returns” (p.102). Hence, gold being highly liquid can serve this purpose. 10. Issues in increasing Share of Gold in Indian Foreign Exchange Reserves Given the precautionary motive of holding foreign exchange reserves in India, as is evident from the high level of deposits with banks, gold can be a prominent asset in the portfolio. What should be the quantum of increase? The international average for the share of gold in the foreign exchange reserves is around 10.5%. While the European countries have over 40%, USA has over 70%. But, the share of gold in Asian countries has been well below the level that India holds. In India, the share of gold is less than 5%. This is in line with many of the Asian economies.
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Role Of Gold In Indian Monetary System As mentioned earlier India is accumulating foreign exchange reserves to meet the requirements of its increasing current account deficit and to protect against volatile capital flows. Though this purpose is served by gold there are other issues. For an emerging economy like India, the reserves should work and earn yield. Keeping large amounts in precious metals which do earn a very low yield cannot meet this objective. If India were to increase the proportion of gold in its foreign exchange reserves to 10%, it would require an outflow of about US $15 billion at the current level of gold prices. Can India afford this is a question to be answered. Though gold is described as a liquid asset, its liquidity vis-à-vis foreign exchange market is low. Average daily turnover in gold is around US $7.3 billion while that of the foreign exchange market is US $1200 billion. Hence, exiting large physical quantities of gold in case of an emergency may is one difficult and secondly will not go unnoticed by the market watchers. To conclude, while it is a clear fact that gold can help diversify and hedge the foreign exchange reserves, how much of it should be held has to be decided carefully given the economic circumstances of an emerging economy like India.
4.4 Gold and risk
Financial instruments usually carry three main types of risk. · Credit risk: the risk that a debtor will not pay · Liquidity risk: the risk that the asset cannot be sold as a buyer cannot be found. · Market risk: the risk that the price will fall due to a change in market conditions. Gold is unique in that it does not carry a credit risk. Gold is no one's liability. There is no risk that a coupon or a redemption payment will not be made, as for a bond, or that a company will go out of business, as for an equity. And unlike a currency, the value of gold cannot be affected by the economic policies of the issuing country or undermined by inflation in that country. At the same time, 24-hour trading, a wide range of buyers - from the jewellery sector to financial institutions to manufacturers of industrial products - and the wide range of investment channels available, including coins and bars, jewellery, futures and options, exchange-traded funds, certificates and structured products, make liquidity risk very low. The gold market is deep and liquid, as demonstrated by the fact that gold can be traded at narrower spreads and more rapidly than many competing diversifiers or even mainstream investments. Gold is of course subject to market risk, as is clear from the experience of the 1980s when the gold price declined sharply. But many of the downside risks associated with the gold price is very different to the risks associated with other assets, a factor which enhances gold's attractiveness as a portfolio diversifier. For example, should a central bank announce its intention to engage in substantial sales of gold, as happened prior to the Central Bank Gold Agreement in 1999; this would be unlikely to have an impact on equity returns but could reasonably be expected to affect the gold price in the short run. Similarly, the specific risks to which bonds
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Role Of Gold In Indian Monetary System and equities are exposed, including pressure on the health of the government and corporate sector during an economic downturn, are not shared by gold. One measure of market risk is volatility, which measures the dispersion of returns for a given security or market index. The more volatile an asset, usually the riskier it is. The gold price is typically less volatile than other commodity prices. This is because of the depth and liquidity of the gold market, which are supported by the availability of large above-ground stocks of gold. Because gold is virtually indestructible, nearly all of the gold which has ever been mined still exists, much of it in near market form. This means that sudden excess demand for gold can usually be satisfied with relative ease. And, unlike many other commodities such as, for example, oil or platinum, the geographical diversity of modern mine production further reduces the chances of supply shocks from any specific country or region having an undue impact on the price. As a consequence, gold is generally slightly less volatile than heavily traded blue-chip stock market indices such as the FTSE 100 or the S&P 500. Gold's extensive appeal and functionality, including its characteristics as an investment vehicle, are underpinned by the supply and demand dynamics of the gold market.
4.5 Gold as a tactical inflation hedge and long term strategic asset
While 2008 was marked by deflation fears, the first half of 2009 saw a growing number of investors express concern over the prospect of resurgence in inflation. Their fears emanated from the aggressive policy responses that were put in place around the world to deal with the financial crisis, alongside tentative signs that the worst of the recession might be behind us. If inflation does materialize, then traditional inflationhedges like gold, commodities, real estate and inflation-linked bonds are likely to outperform other mainstream financial assets. Nonetheless, some investors may be reluctant, at this stage, to add/increase their exposure to specific assets that are recognized as performing well during periods of high inflation, as there are currently equally compelling reasons for inflation to remain low, not least the bleak outlook for consumer spending. This leads us to ask whether any of the four traditional assets that are perceived to perform well during a high inflation environment could demonstrably enhance investors’ risk-adjusted returns even in a low to medium inflation environment, yet provide investors with the peace of mind that they have an asset in their portfolio that is likely to outperform should inflation materially accelerate. Using a portfolio optimizer, we examined the relative performance of four traditional inflation hedges on this basis, over three historical periods and in a forecast scenario, using conservative real return assumptions for each of the inflation hedges. In two of the three historical scenarios, gold proved more effective than commodities, real estate and TIPS, at achieving both the maximum reward-risk portfolio and the minimumvariance portfolio. The required allocation to gold in the portfolio mix to attain minimum variance ranged
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Role Of Gold In Indian Monetary System from 4.0 to 6.3%, while the allocation required achieving the maximum reward-risk ranged from 7.0 to 9.9%. A 6.9% allocation to gold also produced the highest reward-risk portfolio in the forecast scenario, while an allocation to TIPS produced the lowest variance portfolio. We also found a strategic case for gold in the portfolio of an investor that already holds TIPS, thanks to the additional diversification benefits gold brings to a portfolio. Looming inflation and the gold price If inflation is on the horizon it raises important questions for portfolio managers, as traditional assets like fixed-income bonds and equities are not known for their outperformance during periods of high inflation. Investors instead tend to flock to “real” assets or assets that are specifically designed to track inflation. The four most commonly purchased inflation hedges are arguably: gold, commodities in general, real estate and inflation-linked bonds. The last are similar to traditional government or corporate bonds, but with the coupon and principal repayments tied to changes in the general price level, typically the country’s official consumer price index. FIGURE 10: Annual Growth of Gold Prices
Gold’s history as an inflation hedge spans centuries. A cursory glance at gold’s performance in the years since The Golden Constant was first published shows an intuitive relationship between changes in the gold price and changes in the US consumer price index, with peaks in the gold price tending to lead peaks in the CPI.
4.6 Gold in present Market Scenario
Evil-day gold buying really motored since the credit collapse began in August 2007. Soaking up investment dollars worldwide, in fact, new allocations to the metal – whether trust-fund or owned outright – swelled by
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Role Of Gold In Indian Monetary System 38% during the first quarter of 2009 compared with total demand between Jan. and March 2008, according to marketing-group the World Gold Council (WGC). Within that figure, what the GFMS consultancy (who supply the WGC with its data) calls "identifiable investment" leapt 248% compared to Q1 '08. And Gold ETFs made the headlines once more, sucking in "another quarterly record" as new inflows required 465 tonnes of metal to back them, thus dwarfing the previous record of 149 tonnes set in the third quarter of last year. FIGURE11: Gold as a percentage of total Assets
It makes a nice pie chart, and it offers a useful snapshot of different asset classes vs. each other. But here at BullionVault, we also think the idea's worth refining. Because this estimate both over-states liquid assets in toot and under-estimates the stock of gold available to investment flows–whether retail or wholesale. First, note the scope for double-counting between pension, mutual and insurance funds. I'm not saying the WGC's data trips up on that error, but you can see how likely it seems given the end-allocation categories applied. For instance, "hedge funds" are stripped out separately (as are REITs and private-equity), even though institutional allocations via funds-of-funds will be counted elsewhere under the broader "funds" title. Similarly, but more pertinent, the outstanding quantity of "gold – investment stocks" underplays the true volume of metal held as a store of wealth. Simply counting the "investment" volume excludes fully 84% of the above-ground supply, as another chart from the WGC's presentation shows.
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Role Of Gold In Indian Monetary System
FIGURE12: Above ground Stocks
Why not also include "official sector" gold hoards? Sovereign wealth funds and FX reserves were included on the other side of the ledger, after all. More crucially still, why not include jewelry? Trying to split out the volume of trinkets held for aesthetics alone might feel easy enough to a Western analyst just back from window-shopping at Mapping & Webb. But across south-east Asia, and most particularly in India – typically the world's No.1 destination for physical gold each year – large, chunky necklaces and bracelets make for "investment jewelry", acting as a store of wealth in the absence of any formal banking network. In 1968 gold may have represented 4.5% to 5.0% of the world's wealth...By the 1990s it was down to 0.2% of the world's wealth. Not that gold was falling in value so much as the other wealth – stocks, bonds, paper assets, government bonds, corporate bonds, bank deposits – were exploding once the tie to gold was severed. In 2006 gold represented 0.2% of world wealth. At the end of 2007, it was about 0.4%. Depending on what you think about wealth destruction in 2008, it may have been 0.6%. That figure just about matches the WGC's estimate of 0.7% (perhaps they used the same inputs and excluded the same volumes of central-bank and jewelry gold?). It also contrasts with our own Estimate of Gold as
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Role Of Gold In Indian Monetary System a Proportion of Investable Wealth at nearer 2.7% by the close of 2008...which itself shows gold remaining significantly under-invested right now compared with the last two peaks of global investment panic, 1982 and 1932. Does that in itself make gold a buy? Of course not. But compared to the evil days of 1930s depression – or the fearful inflationary panic of the late 1970s – the world's wealth remains very under-invested in metal right now.
4.7 Correlation of Gold prices with various other commodities
TABLE 9: Correlation of Gold prices with various other commodities
Two periods seem to indicate that the relationship between commodities and the dollar becomes stronger during times when the latter is weakening. One possible explanation why this could be the case is that during times of dollar weakness investors diversify part of their capital away from dollar-linked assets. This move can benefit investments in commodities (and in fact has done so in the past), boosting the negative relationship between the two. Moreover, during the 2002-2004 period, the commodities complex received exceptional attention from the financial media, which certainly boosted the sector’s popularity with investors.
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Role Of Gold In Indian Monetary System The unimpressive performance that equity markets demonstrated over parts of the period was another factor that certainly gave commodities further relative appeal. The increased investor involvement in the sector resulted in commodity prices being in greater part driven by speculative activity, boosting the strength of the negative correlation of prices with the US dollar, which was declining at the same time for different reasons. Another interesting fact is that the coefficients calculated for the different commodities vary greatly. The majority of them seem too low to indicate a significant link exists. Performing a statistical test confirms this, and in fact shows that only four commodities’ coefficients are significant for the first period examined, while eight are significant for the second. The commodities that demonstrated significant correlation with the dollar over the first period were cocoa, gold, aluminium and lead. Over the second period, they were gold, silver, unleaded gasoline, corn, soybeans, crude oil natural gas and platinum. Interestingly, none of the coefficients that were found to be significant were positive, in accordance to our expectations (basis the conjecture that, if anything, commodities are expected to be negatively correlated with the dollar). At -0.51, the correlation coefficient calculated between gold and the dollar for the latter period dwarfs all the other statistics we calculated for this section. The second strongest link in the list, the one with silver, is significantly weaker, the correlation coefficient being -0.37. All other coefficients we calculated stood at -0.21 or lower (in absolute terms). It is worth a mention, furthermore, that gold was the only commodity with a significant correlation coefficient over both periods examined. It would thus seem to be the case that, basis the sample examined; gold is a better hedge against the dollar than other commodities. This comes as no surprise, as the yellow metal has always been considered to have an inverse relationship with the greenback4. This relationship is to a large extent self-fuelled, due to investors trading on the back of it. Moreover, the correlation coefficient between the yellow metal and the dollar over the first period examined is a mere –0.19. The difference between the coefficients calculated over the two periods is thus more pronounced for gold than for the other commodities (with the exception of silver, which is discussed later in this report). This fact is in accordance with a known practice in the investment world, that of the “flight to quality”. The term refers to the action of investors moving their capital away from riskier or more volatile assets and into ones considered to be safer and less volatile. The move tends to take place during times of uncertainty in the financial markets and world economy, and reflects some investors’ risk aversion. The second highest (in absolute terms) correlation coefficient calculated was the one between silver and the dollar over the 2002-2004 periods. It is our understanding that the link between the two is indirect and
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Role Of Gold In Indian Monetary System primarily stems from the relationship between gold and silver prices, which GFMS have documented in past publications5. This point is discussed further in later sections of this report. Having examined changes in the prices of the two metals, we have concluded that these show significant positive correlation. As mentioned previously, the remaining six commodities with significant correlation coefficients showed much weaker links to the US currency. Furthermore, none of the six were significant over both periods examined. We can thus deduce that their ability to provide a hedge against changes in the US dollar is very limited compared to gold and, to an extent, silver.
Gold market Report by data monitor Following key points can be highlighted: Market Value The global gold market grew by 18.4% in 2008 to reach a value of $67.2 billion. Market Value Forecast In 2013, the global gold market is forecast to have a value of $75.2 billion, an increase of 11.9% since 2008. Market Volume The global gold market shrank by 4% in 2008 to reach a volume of 2,434.6 metric tonnes. Market Volume Forecast In 2013, the global gold market is forecast to have a volume of 2,436.9 metric tonnes, an increase of 0.1% since 2008. The above clearly shows that the volume of gold is not going to increase too much, but the demand is going to increase. As the result the price is bound to rise.
4.8 Gold Mining Supply 2009
FIGURE 13: World Gold Mining Output Vs Gold Price
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In 2009, Gold mining supply worldwide has failed to grow during the seven-year bull market in gold – and failed badly. Global gold mining output peaked in 2003. Even the record gold price of 2008-09 saw world supply fall. Investors have moved heavily into gold mining companies even as the industry has struggled with declining production. The top 10 gold mining corporations with a combined market capitalisation of nearly $180 billion have seen over 140 per cent returns on their shares, with some giving more than 200 per cent. There have been few new finds which are generally low grade and expensive to develop. The cost & time of bringing new mines into production has escalated dramatically. Also, given the current financial crisis, money is difficult to find for exploration and mine development projects. TABLE 10: Top Gold Mining Companies
In 2004, the top three gold producing countries in the world: 1. South Africa
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Role Of Gold In Indian Monetary System 2. United States 3. Australia In 2008, the top Ten Gold Producing Countries in the world:
1. China – 12.20% 2. USA - 9.90% 3. South Africa – 9.80% 4. Australia – 9.60% 5. Peru – 7.40% 6. Russia – 7% 7. Canada – 4.20% 8. Indonesia -3.80% 9. Uzbekistan – 3.60% 10. Ghana – 3.40%
FIGURE 14: 2008 Gold Production
Source:http://gold.infomine.com/countries/ We increasing demand & decreasing supply, the price of Gold is bound to rise in future. Any new exploration is not going to produce any gold before next five year. As in past, Gold is going to play a major role in enhancing the economy of the gold exporting countries. Gold mining's value to developing countries: Developing countries account for 72% of global output. Most of this come from the low-income or lowermiddle-income countries that together account for two third of the global output. Of the 38 Heavily Indebted Poor Countries (HIPCs), 14 are significant gold producers. For HIPCs as a group, gold accounted for nearly 8% of goods exports and over 6% of exports of goods and services. It is
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Role Of Gold In Indian Monetary System one of the most important exports for HIPCs. Gold is the leading export for Mali (59% of goods exports in 2003), Tanzania (44%), Ghana (32%), Guyana (26%) and the second most important for Guinea (23%). A $10 fall in the gold price would cause a loss of around $75m in HIPCs' export income. Gold is equally important to other low-income countries that are not HIPCs. Among those considered by the World Bank to be severely or moderately indebted, gold is the leading export for Kyrgyzstan (around 45% of total goods exports in 2003) and Papua New Guinea (36%), the second most important export for Mongolia (20%) and Zimbabwe (11%) and one of the two leading exports for Uzbekistan. Among lowermiddle-income countries, gold is the leading export for both South Africa (13% of goods exports in 2003) and Peru (17%). Gold mining companies source supplies locally where possible and employ local labour where possible. Thus, even allowing for some necessary imports and for the remittance of profits and dividends, their impact on a developing country's balance of payments is strongly positive. Export revenue is not the only benefit gold mining brings to a developing country. It provides royalty and tax income to governments, technology transfer, skilled employment and training for local populations, together with further jobs through the multiplier effect. In one or two cases it has provided the foundation for a significant jewelry manufacturing industry. Gold mining can also bring substantial improvements in physical, social, legal and financial infrastructure. The establishment of a formal mining industry can be the first step in a country's industrial development. Mining is a foundation industry that often provides the critical mass for the development of electricity, water, road and rail transport in a region. This characteristic of the industry is particularly important in Africa where lack of infrastructure has been identified as one of the major hindrances to economic development. Gold mining brings benefits to poorer nations. It will continue to have a role to play in fostering economic development. But the economic development may change hands, depending upon the largest exporter of Gold. Since the supply is decreasing, the nations where production would decrease can lead to increase in unemployment. Since the gold mining workforce is highly specialized, they might find difficult in finding new jobs.
4.9 Gold as tool to hedge against US Dollar currency
US dollar has lost more than 40 per cent of its value since 2001 as measured by the dollar index, which tracks the dollar against a basket of major currencies, including the euro, yen and pound sterling.
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Role Of Gold In Indian Monetary System FIGURE 15: Gold as tool to hedge against US Dollar currency
Source: London Bullion market - www.lbma.org.uk/ Foreign exchange (INR v/s Dollar) data & Gold price for the last fifteen years was collected and analysed. First, for the price of gold we used the daily London PM gold fix; this price is quoted in US $ per troy ounce. The fix is at 10:30 AM London time. The source for the raw data series is the London bullion market. While gold is traded in markets throughout the world, the market is essentially Homogenous since the price is always in dollars and the gold traded is “loco London” (gold deliverable in London and meeting London trading standards). The London PM fix is normally considered the main reference price for the day and is the price most often used in contracts. The gold fix takes place twice daily at 10.30am and 3pm, London time.
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Role Of Gold In Indian Monetary System The weekly gold price, which can be seen to range from about $400 at the beginning of 1995 to a maximum of $1100 in 2009. Such wide fluctuations are much greater than those observed in the exchange rates and it was therefore decided to transform the series by taking logarithms, which has the effect of compressing scale and hence stabilising the variance of the data. It could be seen from the above graphs, whenever the dollar value decreased, the gold price increased. Gold Price & dollar value are negatively correlated. Gold is indeed a hedge against fluctuations of the US$ on the foreign exchanges. The Theoretical Case for gold providing a hedge against the US Dollar Having established the statistical case for gold being superior to other commodities as a hedge against the dollar, it is interesting to examine the theoretical properties behind this attribute the metal seems to possess. What are the reasons that make gold is a suitable instrument for hedging against the US dollar, and more specifically, what are the reasons it is a more suitable instrument in this regard, compared to other commodities? • First of all, like all physical commodities, gold is an asset that bears no credit risk. Holding assets in the metal involves no counterparty and is no one’s liability. This of course does not apply to investments in paper gold products, which by definition involve an issuing institution. In addition to that, the physical properties of the metal make it an excellent alternative to money. Gold is durable. • Unlike many of the other commodities examined, other things remaining equal (i.e. assuming no changes in price), there is no depreciation in the value of gold, other than any storage costs that might apply. Gold is fungible • • It is, at least in theory, infinitely divisible with virtually no losses (other than any operational costs the process might incur). Furthermore, gold has a high value to volume ratio, which makes it easily transferable, with low transport and storage costs. Moreover, gold is one of the deepest commodity markets with the highest liquidity. At end-2004, above ground stocks of gold, defined as cumulative mine production, stood at roughly 153,000 tonnes (source: GFMS, Gold Survey 2005), translating to over $2.1 trillion (using the end-2004 gold price). As a point of reference, the equivalent figure for silver, the second most strongly correlated commodity to the dollar according to our analysis above, is less than $0.2 trillion. This liquidity of the gold market conveys financial characteristics on the metal, thus making it a suitable alternative to fiat money. The most important such property though, is gold’s legacy as a monetary commodity, and the fact that investors treat and trade it as one.
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Role Of Gold In Indian Monetary System For a great part of human history, large parts of the world accepted the metal as the ultimate store of value. In fact, it was not until the 1970s that gold stopped being the benchmark for the international currency market. After the move to a system of floating fiat currencies, and currency and inflation risk developed, so did the need to hedge against this risk, using some sort of hard, value-retaining asset. The natural choice for this was and has been the commodity that had in the past acted as such, namely gold.
4.9 Gold's value as a currency reserve
Gold is still considered an important reserve asset by most central banks, even though it is no longer the centre of the international financial system. The most important reason is that gold is the only reserve asset that is no one's liability. This means that, unlike a currency, the value of gold cannot be affected by the economic policies of the issuing country or undermined by inflation in that country. Gold has a track record of holding its real value over the centuries. Since gold is no-one's liability, it can not be repudiated and holding it is a safeguard against potential unforeseen crises. Gold also brings much needed diversity to a central bank portfolio due to its low correlation with key currencies and its strong inverse correlation with the US dollar. FIGURE 16: Gold reserves as the percentage of total reserves for United States
Gold reserves as the percentage of total reserves for United States FIGURE 17: Gold reserves as the percentage of total reserves for India
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Gold reserves as the percentage of total reserves for United Kingdom
Gold reserves as the percentage of total reserves for India FIGURE 18: Gold reserves as the percentage of total reserves for China
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Gold reserves as the percentage of total reserves for China
Source: Data for all graphs:http://www.reserveasset.gold.org/
RBI’s decision to shore up its gold reserves needs to be seen in the context of other central banks across the globe increasing their gold reserves. Among them are the central banks of China, Russia and a few countries in the European Union. In the last one year, China has increased its gold holdings, by weight, by 75.69%, Russia by 18.78%, the Philippines by 18.50% and Mexico by 108.91%. Compared with this, India’s central bank did not add anything to its gold reserves in the last one year, according to Bloomberg data. In fact, the share of gold in India’s total reserves has dwindled over the decade. In March 1994, the share of gold in the total reserves of the country was 20.86%; by the end of June 2009, gold constituted only 3.7% of the total reserves. RBI’s foreign currency assets consist mainly of sovereign bonds, mainly US treasuries. So, buying more gold will help the Indian central bank diversify its assets. Gold is the ultimate currency. In fact, only gold came to our rescue during (the) 1991 crisis, so it makes sense that RBI should try to increase its gold holdings. RBI's foreign exchange reserves consist of foreign currency assets, gold, special drawing rights (SDR) an international reserve currency floated by IMF and RBI funds kept with IMF. Out of RBI’s $285.5 billion foreign exchange reserves, foreign currency assets account for the most $268.3 billion followed by gold ($10.3 billion), SDR ($5,267 million) and reserve position in the IMF ($1,589 million). According to RBI’s latest annual report, the foreign currency assets consisting of foreign securities declined by Rs81,010.25 crore from Rs12.98 trillion on 30 June 2008 to Rs12.17 trillion on 30 June 2009 mainly due to net sales of dollars in the domestic foreign exchange market.
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Role Of Gold In Indian Monetary System At the current market value of $1,054 an ounce, or per 28.5g, RBI would need to spend about $7.4 billion to buy 200 tonnes of gold. With this, its gold reserve will rise to $17.716 billion, or roughly 6.20% of the total reserves.
4.10 Gold Consumption in India
India is the most lavish gold consumer in the world. No one can miss the sign of a gold shop, if he travels across any Indian city. A small village town called Chavakkad in central Kerala, a southern Indian state that consumes 20% of all gold sold in the country, has more than 115 glittering gold jewellery shops! And it is not just the village towns. Travel to Zaveri Bazaar, the nerve centre in Mumbai, India’s financial capital. Thousands of bullion traders and dealers carry out global trading in gold from here. Gold prices may be zooming world over. This week, the yellow metal glittered as it touched a record high of $1225 per ounce! Now, analysts from Jim Rogers to Jim Sinclair are predicting that gold is the hottest investment asset compared to the declining US dollar, and thus the yellow metal prices will soar above $2000 per ounce in the next decade, beginning 2010. But despite this huge rise in gold prices—the yellow metal prices gained by more than 39% in 2009— Indians continue to buy gold. They buy gold ornaments for the marriage of daughters. They buy gold jewellery during festival seasons. They buy gold coins from banks, post offices and brokerage houses and keep them in safe lockers as future investment. India remains the darling consumer of the bullion trading industry. No bullion analysis daily misses to mention India when it comes to gold trading, consumption and imports. According to an estimate from the World Gold Council (WGC), India is set to consumer or buy around 700 tonnes of gold in the year 2009. In 2008, India’s gold buying was higher at 900 tonnes. Bullion traders and WGC say that gold consumption has declined in India this year thanks to the skyrocketing prices of the yellow metal. Ditto is the case with India’s gold imports. Last year, India imported 712 tonnes of gold. Gold imports this year is expected to plunge to around 450 tonnes thanks to the dropping sales of gold on high price. India’s total gold holding is between 10,000 tonnes and 15,000 tonnes of which the Reserve Bank of India has only around 600 tonnes. While India is the proud, No 1 consumer of gold in the world, that golden status may move over to China by next year. Bullion analysts and WGC have already forecast that China may overtake India in gold consumption soon. Increased love of Chinese for gold may cause a huge rise in gold jewellery sales in
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Role Of Gold In Indian Monetary System China. According to market analysts, middle-class buyers in China, the second-biggest gold user, drove a 16 per cent gain in gold and silver jewellery sales in the first nine months. China’s economy grew 8.9 per cent in the third quarter, the fastest pace in a year, and the World Gold Council said in July that the nation may pass India as the biggest consumer. Bullion is on course for its ninth annual gain after the dollar weakened and demand for gold as a store of value increased. The Chinese have only started to buy gold as an investment product, and there’s huge room for this sector as the middle class grows.
4.11 Pattern of gold investment in India:
We conducted a small research to find out, what patterns/trends were visible in the investment patterns of Indians. The rate of savings of Indians has been on an increasing trend since 1970’s as indicated in the graph below. The GDP and the savings rate have been increasing proportionally.
FIGURE 19: The GDP and the savings rate of India
40% 35% 30% 25% Savings/GDP 20% 15% 10% 5% 0% FY71 -5% Gross Household Savings/GDP Private C orporate Savings/GDP Public Sector Savings/GDP GDP FY76 FY81 FY86 FY91 FY96 FY01 FY06 FY07 FY08 -200 1600 1400 1200 1000 800 600 400 200 0
Source:
Edelweiss Research report
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GDP (USD billion)
Role Of Gold In Indian Monetary System
On the other hand the gold prices show an increasing trend as shown in the graph below
Source: Timothy Green's Historical Gold Price Table , London prices converted to U.S. Dollars.
With the assumption that increasing prices of gold also reflect the household demand of gold in India, we can conclude that investment in gold has not been increasing at the rate of increase of GDP in India. The investment in gold has picked up around 2001 during times of the dot com bubble when the market was bearish towards the equity investments. Investment in gold also sees an increasing trend during 2007-08 when most of the major countries was reeling under recession. Indians like to keep major part of their investment in gold, but their rate of increase in gold has not kept pace with the increase in the disposable income/national income.
4.12 The gold versus equity
The precious metal’s recent spectacular run from sub-$1,000-per-troy-ounce-level in the international markets to record highs of over $1,055 per ounce. The metal has jumped by around 20% this year, and after this week’s massive rally, is all set to record its ninth consecutive yearly gain. In a span of just days, the metal first crossed the $1,000-mark and then topped its all-time record of $1,034 per ounce. In India, the world’s largest gold consumer and with one of most well-performing stock exchanges, a rupee invested in gold bars in 1998-99 would have given a return of around Rs 197 in 2008-09. This means, in 10 years, investment in 10 gm of gold bar in India would have risen by 197%. Around the same time, one rupee invested in the BSE sensitive index would have given a return of around Rs 345 by 2008-09.
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Role Of Gold In Indian Monetary Systemhttp://www.financialexpress.com/news/the-gold-versus-equity-story-is-changing/527832/In
other words, stocks have outperformed gold for most of the last decade, albeit minor aberrations like in 2002-2003 and 2001-2002 when the return on the BSE Sensex was less than that on gold. In 2006-07, RBI data shows that 10 gm gold prices in Mumbai rose around 34% as compared to last year while the 30-share BSE Sensex rose 48.3% as compared to the previous year. Similarly, in 2005-06, gold prices in Mumbai spot markets rose 12.3% as compared to the previous year, but the BSE Sensex climbed around 44.2%. In other words, in all these years, investment in stocks would have given a layman better returns than in gold. Experts believe that a big reason for this was that the years 2005 and 2006 were marked by high GDP growth rate in India that propelled stock markets to dizzying highs. Even a data from the World Gold Council (WGC) shows that in the last five years, returns on the main 200 stocks listed in the Bombay Stock Exchange (BSE) have grown.
FIGURE 20: Gold Rush
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Chapter 5: Conclusion
In the world’s financial and political capitals, India — now sitting on the fifth largest stash of foreign exchange among all countries — was seen to be flexing its muscles with its dramatic dollar-for-gold swap. But there’s another, even bigger, game in play here: Asian economies are hedging against a weakening US currency The reason is straightforward: faith in the world’s biggest economy, the US, and its currency is sliding. The US economy is beset with multiple problems — 10 per cent unemployment, a mind-boggling budget deficit, spiraling mortgage and credit card defaults, and persistent toxic assets on bank books — due in large part to years of unsustainable spending. By exchanging dollars for gold, India, China and other developing countries are hedging their bets, thus delivering an implicit vote of no-confidence in the dollar. In the past year, the dollar has declined by over 16 per cent, contributing in part to the increase in gold prices. With a big buyer like India stepping in and buying 200 tonnes of gold, both these trends received a fillip. The price paid by India virtually set a floor for international gold prices while further confirming the sentiment that the dollar was in trouble. US November data about increasing unemployment and foreclosures worsened the situation for the greenback. And hence gold is definitely going to play a major role in the future monetary system. The future role has been concluded below based on the analysis in this report:
5.1 Gold mining's value to developing countries
Gold mining is vital to the fragile economies of many impoverished countries, which account for roughly two-thirds of global gold production. In addition to generating export revenue in these countries, gold production provides royalty and tax income to their governments, technology transfer, worker training and the creation of a skilled workforce. Gold mining can also bring substantial improvements in physical, social, legal and financial infrastructure. In many of these countries, gold mining is a foundation industry that often provides the critical mass for the development of electricity, water, road and rail transport in a region, that are the essential foundations of an economy. Gold is often thought of as synonymous with wealth. Yet gold coins, bars and high-carat jewelry play a crucial role as a means of saving and defense against misfortune to many of the poor of the world. Similarly gold mining brings benefits to poorer nations. It will continue to have a role to play in fostering economic development.
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5.2 Gold as a preserver of value inflation hedge, safe haven.
While 2008 was marked by deflation fears, the first half of 2009 saw a growing number of investors express concern over the prospect of resurgence in inflation. Their fears emanated from the aggressive policy responses that were put in place around the world to deal with the financial crisis, alongside tentative signs that the worst of the recession might be behind us. If inflation does materialize, then traditional inflationhedges like gold, commodities, real estate and inflation-linked bonds are likely to outperform other mainstream financial assets. Nonetheless, some investors may be reluctant, at this stage, to add/increase their exposure to specific assets that are recognized as performing well during periods of high inflation, as there are currently equally compelling reasons for inflation to remain low, not least the bleak outlook for consumer spending.
5.3 Gold's value as a reserve
Gold is still considered an important reserve asset by most central banks, even though it is no longer the centre of the international financial system. The most important reason is that gold is the only reserve asset that is no one's liability. This means that, unlike a currency, the value of gold cannot be affected by the economic policies of the issuing country or undermined by inflation in that country. Gold has a track record of holding its real value over the centuries. Since gold is no-one's liability, it can not be repudiated and holding it is a safeguard against potential unforeseen crises. Gold also brings much needed diversity to a central bank portfolio due to its low correlation with key currencies and its strong inverse correlation with the US dollar. To conclude, while it is a clear fact that gold can help diversify and hedge the foreign exchange reserves, how much of it should be held has to be decided carefully given the economic circumstances of an emerging economy like India.
5.4 Gold's value in industrial applications
Gold ranks among the most high-tech of metals, performing vital functions in many areas of everyday life. Gold's unique properties make it useful in medical applications, pollution control, air bags, mobile telephones, laptop computers, space travel, and many other things we consider indispensable to our modern lives. Approximately 12% of demand for gold comes from industry
5.5 Gold's value as an effective portfolio diversifier
Gold is an effective hedge against inflation. In addition, gold is inversely correlated to the US dollar, making it a good currency hedge. As an asset class, gold has all the advantages of being universally regarded as a currency, without what are all too often the disadvantages of being subject to the economic and monetary policies of one particular country's government
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5.6 Gold's value to consumers and investors in developing countries
In much of Asia, the Middle East, and the Indian subcontinent, gold is the best possible protection against upheaval, both political and economic. For men and women throughout the developing world, gold is still one of the most liquid and widely accepted forms of exchange, quite simply the most efficient store of value they possess. Around two thirds of the jewelry purchased in the Middle East and Asia is used as a means of saving in addition to its function as an adornment. The use of jewelry as savings is often important in rural areas where access to a reliable and appropriate banking system is difficult or impossible. Gold also offers protection against a weak currency or high domestic inflation levels, which are prevalent and persistent problems in the developing world. Around two thirds of all jewelry manufacture takes place in the developing world and the proportion is rising. Countries such as Turkey, India, China and Thailand have all seen their exports to developed countries rise in the last few years, generating export earnings and employment. Gold jewelry sales to tourists are also important for Turkey, Egypt and Dubai.
5.7 In India, you’re in gold’s own country
The glitter of gold has attracted Indians for centuries for a variety of reasons — ranging from a medium of transaction to protecting wealth, securing the future and as jewellery. In the recent past, the volatility of the stock markets has only added to the luster of the yellow metal. The fact that gold has traditionally been considered a hedge against inflation and a depreciating dollar too has fuelled its demand. It is estimated that about 15,000 tonnes of gold is privately held in India, more than twenty-five times as large as the official hoard of 558 tonnes after the RBI’s recent purchase of 200 tonnes from the International Monetary Fund (IMF). Gold is valued in India as a savings and investment vehicle and is the second most prefered investment behind bank deposits. Gold purchases in Kerala and Tamil Nadu are almost exclusively meant for weddings, but among the relatively more market savvy Gujaratis, Marwaris and other business communities, gold buying is also driven by the metal’s attractiveness as an investment. Religiosity too seems to make common cause with the most universally recognized symbol of material wealth. Whether it’s for security, returns or other purposes, what’s clear is that India’s hunger for gold remains insatiable.
5.8 Impacting Factors affecting price of Gold
Today, like all investments and commodities, the price of gold is ultimately driven by supply and demand, including hoarding and disposal. Unlike most other commodities, the hoarding and disposal plays a much bigger role in affecting the price, because most of the gold ever mined still exists and is potentially able to come on to the market for the right price. Given the huge quantity of hoarded gold, compared to the annual
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Role Of Gold In Indian Monetary System production, the price of gold is mainly affected by changes in sentiment, rather than changes in annual production.
5.9 Future Outlook
The future of gold mining is dim. All the gold that has ever been extracted by humankind amounts to about 160,000 tonnes. There have been few new finds and most of the known deposits have been drawn down. Those that remain are generally low grade and expensive to develop. The cost of bringing new mines into production has escalated dramatically. The timeframe from exploration to production can be 5-10 years, which has slowed new production coming into the market. Also, given the current financial crisis, money is difficult to find for exploration and mine development projects. There is gold in seawater, but it would be too expensive to recover. You can actually turn lead into gold but the cost is prohibitive. So, with not much new gold coming in, and the international currency system on shaky legs, a new gold rush is on. Gold in all shapes, sizes and forms — bangles, bracelets, necklaces — is pouring into gold-refining centers, where it is converted into bars and ingots for investors who are looking to park their money in something more solid than the dollar.
5.10 So, Are we moving into bubble territory?
Gold prices could move considerably higher still if the “weight of money” entering the market from investors is sufficient. But signs of a bubble are apparent. For instance, the fact that scrap supply in some countries is now larger than local jewellery demand. The bubble could get a lot bigger, though, before it bursts, (but) that will be the eventual outcome. In the meantime, though, other central banks are expected take a cue from the RBI and look to diversify their foreign exchange portfolio — ie, sell dollars and buy gold. In the face of falling confidence in the dollar, the chairman of the Federal Reserve took the rare and unusual step of trying to “talk up” the currency — rare, because in the US it’s the treasury secretary who’s generally responsible for the health of the currency. The US can now only hope that India & China, despite their growing misgivings about the dollar, won’t pull the rug from under the currency since that would seriously affect the value of the trillion-plus dollars they have invested in US securities. It’s an irony that the fate of the dollar doesn’t really lie in America’s hands. It is countries such as China and India that are deciding what happens in currency markets. That’s even as they add a bit of glitter to their forex reserves.
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Chapter 6: Bibliography
• Aggarwal, R., 1992, Gold Markets, in: Newman, P., Milgate, M., Eatwell, J. (eds.) The New Palgrave Dictionary of Money and Finance (Vol 2), Basingstoke, Macmillan, pp. 257-258. • Aizenman, J. and N. Marion, 2003, The High Demand for International Reserves in the Far East: What is Going On?, Journal of the Japanese and International Economics, 2003, 17/3, pp.370-400. • Archer, D. and J. Halliday, 1998, The Rationale for Holding Foreign Currency Reserves, RBZN Bulletin, 61(4), 346-354. • Chopra, A., C. Collyns, R. Hemming, K. Parker, W. Chu and O. Fratzscher, 1995, India: Economic Reforms and Growth, IMF Occasional Paper 134, International Monetary Fund, Washington. • Ghosh, D., E.J. Levin, Macmillan, Peter and Wright, R. E. (2002), Gold as an Inflation Hedge, Department of Economics, University of St. Andrews in its series Discussion Paper Series, Department of Economics with number 0021, Macmillan. • • • • • • • • • Garcia, P. and C. Soto, 2004, Large Hoarding of International Reserves: Are They Worth It?, Central Bank of Chile Working Paper No. 299 International Monetary Fund, 2003, Are Foreign Exchange Reserves in India too High?, World Economic Outlook, September, Washington. International Monetary Fund, 2004, Guildelines for Foreign Exchange Reserves Management, Washington. Kim Y., 2000, Causes of Capital Flows in Developing Countries, Journal of International Money and Finance, 19, 235-253. Mani, G. and Vuyyuri S., 2004, Gold Pricing in India: An Econometric Analysis, athttp://ssrn.com/id=715841 Mohanty, M.S., P. Turner, 2006, Foreign Exchange Reserve Accumulation in Emerging Markets: What are the Domestic Implications?, BIS Quarterly Review, 39-52. Nugee, J., 2000, Foreign Exchange Reserves Management. Handbooks in Central Banking No. 19, London: Centre for Central Banking Studies, Bank of England. Reddy, Y.V., 2006, Foreign Exchange Reserves – New Realities and Options, available at www.bis.org/review/r060921c.pdf Rodrick D. and A. Velasco., 1999, Short Term Capital Flows, NBER Working Paper No. 7364. Page 74
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• Summers, L.H., 2006, Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation, L.K. Jha Memorial Lecture, Reserve Bank of India, available at www.rbidocs.rbi.org.in/rdocs/publications. • Williams, D., 2003, The Need for Reserves: How Countries Manage Reserve Assets, 3344, London: Central Banking Publications. • • • • Gold Production and Consumption Indices by Gold Field and Mineral Services Ltd BRIC report, BRIC and the world Commodities market World Gold Council, IIFL Research RBI and
Links:http://goldnews.bullionvault.com/gold_fear_052120093http://www.reuters.com/article/idUSTRE51N2PO20090224http://news.goldseek.com/SpeculativeInvestor/1171382460.phphttp://hubpages.com/hub/Why-to-invest-in-GOLD-and-How www.utilisegold.com
www.gold.org.inhttp://www.kitco.com/charts/historicalgold.html www.goldbarsworldwide.com www.bullionVault.comhttp://www.kitco.com/charts/historicalgold.html
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Chapter 7: Appendix
Questionnaire:
Name: Marital Status: Single/Married
Gender: Male/Female Age: years
1.
What is your Occupation? a) Salaried
b) Self Employed c) Student
d) Others
2.
What is your annual income? a) < Rs 120000
b) Rs 120000-Rs 250000 c) Rs 250000-Rs 500000
d) Rs 500000-Rs 1000000 e) > Rs 1000000
3.
What percent of your annual income do you save? a) < 10%
b) 10%-20% c) 20%-30%
d) 30%-40% e) > 40%
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4.
What is your primary investment objective? a) Highest potential returns
b) Growth of Income c) Income
d) Preservation of Capital
5.
What is your investment horizon? (Time until you need to withdraw cash from your investments) a) More than 10 years
b) 5-10 years c) 2-5 years
d) 1-2 years e) Less than 1 years
6. How predictable (or stable) and sufficient is your source of income? a) Unpredictable, making it difficult to budget or invest
b) Somewhat predictable, but can fluctuate from month-to-month c) Reasonably predictable, with some excess to invest from time-to-time
d) Predictable and sufficient to allow for periodic investment e) Very predictable with large excess to invest on regular basis
7.
What all investments you are aware of (Tick)? a) b) c) d) e) f) g) h) i) j) Equity/Shares Non Convertible Debentures/Bonds Bank Deposits/Saving Account/ Recurring Account Provident Funds/Pension Schemes Life Insurance Mutual Funds Commodity Trading Gold Deposits Real Estate Fixed Deposits(FDs)
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8. From the above investments rank it on the basis of your priorities? Codes a) Equity/Shares b) Non Convertible Debentures/Bonds c) Bank Deposits/Saving Account/ Recurring Account d) Provident Funds/Pension Schemes e) Life Insurance f) Mutual Funds g) Commodity Trading h) Gold Deposits i) Real Estate j) Fixed Deposits(FDs) E NCDs BD PF LI MF CT GD RE FD Rank %age of Investment
9.
Fill the boxes below with the codes of the investment given above, According to your perception of risk & return associated with it: Return Risk
High (Greater than 30%) Medium (11-30%) Low (20%
b) 10%-15% c) 5%-10%
d)