Gold's Economics

How the economics of Gold work to make it attractive to investors as money...

WHAT FACTORS EXPLAIN the glitter of gold for investors today? asks Sandesh Kirkire, CEO of Kotak Funds, in Commodity Market, India's leading investment trading magazine.

   If we start with the basic factors, the reasons are simple. Ponder a little history of the human economy, and you will realize that despite all the prosperity since civilization began, Gold alone still carries its significance from that time. And, despite all the conjecture during the 1990s that gold was slowly being relegated to disuse, the fetish and economics behind this metal remain firmly in place.

   But why? Because 'money' is only as good as the 'exchange' it can bring for you, either now or later. And this is largely dependent on the willingness of the second and third parties down the line from your purchase to accept your 'money' as good. This is where gold comes in.

   Gold's 'value' is thus embedded in human history and collective psychology. It derives its economic value from the basic human urge to possess its rarity and beauty. And it is this natural ability of drawing human possessiveness that makes gold as the natural currency of the world, and helps gold display characteristics quite perfect as 'everyday money'.

   The economics of gold as determined by demand and supply factors reveal some interesting facts, indicating the underlying momentum – as well as the partial rationale for this decade's bull market. Gold jewelry demand comprises around 64% of the total global gold consumption. Aggregate investment in gold comprises 20% of the total global gold consumption (Q1-2008). What makes Gold an interesting preposition is that fresh gold supply has stood around only 62% of the total global demand since 2005, with remaining demand being met by old scrap and previous holdings.

   It was, therefore, no surprise that Gold Prices remained continually upbeat during the period. International gold prices, as depicted by the London bullion market, delivered 19% annual growth in the 2002-2008 period. But there is more to this bull rally than simply the demand and supply equation.

   The rally in Gold Prices also stems deeply from the complex relation it shares with the US Dollar and crude oil, inverse with the former and direct with the latter. Since late 2007, the US Fed has acted to bolster its decelerating economy by drastically reducing the interest rates. The collateral effect of this was the weakening of international investor confidence in the Dollar. People consequently scrambled to acquire value in other commodities, especially oil and Gold.

   To put that in perspective, in just the last year alone, gold has rallied by nearly 36%, while oil has moved by 86% till date.

   Furthermore, it is expected that as the US economy declines further, the Gold Price may gather further steam. It is due to this very reason – financial crisis and economic concern – that gold held by Exchange-Traded Gold Funds risen strongly over the last year.

   Some may rightly argue that this was largely due to the low base effect. Yet it is important not to overlook the fact that Gold Investment demand – led by Gold ETF trading – has been the only segment of gold consumption to grow positively and overwhelmingly so far in 2008.

   Thus with crude oil touching $150 per barrel in the short run, and forecast to reach as high as $200-400 in the medium to long run, the possibility that Gold – which has been highly 'oil co-related' – will remain dormant is unlikely.

   Even with a historical low on the Gold:Oil Ratio of six barrels per ounce, gold is projected to grow to $1,000 if oil goes to $150. So in the medium to long run, if the relationship with oil holds good and oil continues to rise, the possibility of further gains in gold remains stronger than ever.