Investment is always fraught with risk. And with most investments losing value in recent times, many people have begun looking at gold again. But is it safe to invest in gold? There are three ways to answer this question.
The first is the price at which it is bought. Like any commodity, there are highs and lows. If gold is purchased at the high level in its price cycle, it will take some time to recover cost of investment.
A classic situation took place in 1980 where for a short time on a single day, gold prices scaled $800 (Rs39,920 now) an ounce. Those who bought gold then had to wait for at least 20 years before prices reached that level again.
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Another way of looking at gold is as a hedge against inflation. Gold has (almost always) registered higher average price increases than average inflation rate in most countries. Moreover, unlike any other commodity, it shows little volatility.
The third way to look at gold is how its price appreciates. For instance, if one considers a 20-year period (the normal time frame for an individual to encash the benefits of his savings), gold was a marvellous investment in dollar terms. But as Indian prices were always higher than international prices, anyone who invested in gold at prices prevailing at that time will feel the pain of not seeing his investments pay off. So, never buy gold in India without comparing international prices.
When central banks sell gold
Any investor would be right in trying to find out why gold prices did not rise much from 1985 to 1998. There are three major factors. One is speculative forces. It may make sense for investors to compare spot prices of gold at which the metal is purchased and then compare them with gold futures prices for three-month and six-month positions. If the difference is too great, be cautious.
The second is to keep a lookout for gold sale by central banks of countries, which usually happens when the dollar is strong. This is because the world normally backs one major currency or commodity at a time. When the dollar is strong, money gravitates to it, and when it is perceived to be weak, a lot of money parks itself in gold at such times.
During the 1990s, most European countries and a few others (plus the International Monetary Fund, or IMF, and the European Central Bank by tacit consent) decided to enter into an agreement—the Central Bank Gold Agreement, or CBGA—that gold would continue to remain an important element of global monetary policy. But they also recognized the need for central banks to sometimes sell gold to meet domestic financial obligations.
Yet, to prevent a glut in the market, or to avoid the possibility of two sellers opting to sell at the same time, as also not to disrupt the gold market excessively, they also decided to sell not more than 2,000 tonnes during the first five years of 1999-2004 (CBGA1).
This agreement was renewed, and CBGA2 became effective fromSeptember 2004, and is valid till September 2009—CBGA2 capped annual sales collectively at 500 tonnes and total sale at 2,500 tonnes. It is likely 480 tonnes more will be sold between now and September. Experts say IMF could be a likely seller as the US may not be able to finance its operations.
Now, with the world facing a financial meltdown, and investors losing faith in commodities, the dollar and the euro, confidence in gold as an investment alternative has begun to climb.
So, chances are more countries will seek to augment, not diminish, reserves. Yet, it must be remembered that with all countries collectively holding 29,813 tonnes of gold, any sizeable sale by a country could cause prices to soften.
The third factor is country purchases. Most experts believe that the present financial meltdown will see less countries selling gold, and more investing in it. Gold continues to be a major indicator of the economic strength of a country and its currency. Market men have also been looking at China’s moves, as it has begun purchasing gold—albeit for jewellery. But it could start diversifying its dollar assets and invest some of it in gold. If that happens, be prepared for a bull run on gold.
How low can prices go?
Most gold experts agree the bottom support for gold prices will eventually be close to the price at which it is produced. The biggest costs in gold production are electricity, followed by labour.
One of the biggest producers of gold, South Africa, is likely to see a surge in power costs as it had to negotiate a deal for uninterrupted supply to ensure production does not suffer. Except for a brief period when central bank sales were high, gold prices have always hovered above total mining costs.
An area that needs watching is the premium investors in some countries pay for gold if they buy it locally. India is particularly vulnerable in this respect. Indian prices have usually been higher than UK gold prices. At times this premium can be as high as 60%.
India allows import by individuals in the form of bars only if they have stayed overseas for more than six months. If such norms change, there is a good possibility that such premiums could fall.
Today, since import of gold is only permitted by designated banks and five-star export houses, the trade gets much of the benefit. Any investment decision must necessarily take this difference between domestic and international prices into account as well.
It is also important to keep monitoring the actions of the biggest producers of gold. What these producers do on a month-by-month basis would be a critical factor in determining the way gold prices move. Lest anyone thinks this column recommends investing in gold, it is worth bearing in mind a memorable quote from Mark Twain: Prophecy is a good line of business, but it is full of risks. Need we say more?
R.N. Bhaskar runs a company with significant interests in distance learning and examination certification and writes on corporate and business policy issues. Comments on this column are welcome at firstname.lastname@example.org
Graphics by Ahmed Raza Khan / Mint