Gold at 21K. That's a real salute to Women on Women’s Day!

Two headlines grabbed my attention in these last two days. One said something about Indian men being amongst the biggest MCPs in the world. And the other one about gold scaling Rs 21,000 per 10 gms. Both stories are in the context of women. To me, it is proof enough that Indian women have always been very very smart. Clearly they have shown their preference for Gold than for men!

On a more serious note, what’s driving up the price of Gold so much? In the last 5 years, the price of Gold as measured in Dollars has more than doubled. In fact, it has grown from about $440 per ounce to nearly $1300 today. As usual, there is a simple economic reason for this behavior and this post examines just that.

All prices are driven by the balance of supply and demand. When the demand for Gold rises, the prices also rise. Demand for Gold is made up of two types of buyers: One is the household buyer....the Indian woman for eg. And the other is the institutional buyer....the investors who bet on Gold’s prices. Since institutional traders of Gold are far higher in number than actual consumers, the price of Gold is determined by international trading in Gold rather than by household purchase.

It is also important to understand that Gold is considered to be “alternate currency”.....or alternate to currency. The usual currency we use is obviously the Re or the $ or the Euro or whatever. The alternate currency is the Gold.

So lets understand currencies better. Here’s something that’s not very well known to most of us Indians. Worldwide, currencies are considered an investment option (just like shares or debentures or Gold). So Americans who want to invest their savings could take a call to park their Dollars in (say) Euros or Yen rather than keeping it in Dollars. And if the Euro were to appreciate, they could convert it back into Dollars and get a larger sum in hand. If we as Indians could do this, we would convert our Rupees into Dollars when the Rupee was strong (say Rs 40 per Dollar) and then convert it back into Rupees if the Rupee became weak (say Rs 45 per Dollar). For such investments to be allowed, the currency needs to be fully convertible. The Indian rupee is not a fully convertible currency and hence you and I are not allowed to convert our Rupees into Dollars at our free will. We are not allowed to invest in currencies. In fact, there are stringent laws in India which compel people who earn Dollars (for eg, exporters) to convert the same into Rupees.

Now let’s understand why the price is going up so much. Basically, since Gold is an alternate currency, the price of Gold goes up when people lose faith in the usual currency. So rather than keep their savings in Dollars or Euros, they prefer to buy Gold and keep it in the form of Gold. And since the time Gold was “dematerialized” (this means that you don’t need to take physical delivery of Gold.....you can take in the form of demat like you can with shares), it has become very easy to buy and sell Gold.

Why has the usual currency lost favor? Largely, because it is getting devalued because of various factors. The biggest factor that causes a currency to lose its value is inflation. When the same Dollar can only buyer fewer goods, then it loses value. In India, we are used to inflation and we are used to our currency losing value! It’s not that common in the developed world. The same factors that cause inflation are the ones that lead to the fall of usual currency and the rise of Gold prices:

1)      Oil: One of the major reasons for high inflation currently is the price of oil. With the crises spiraling out of control first in Tunisia; then Egypt and now Libya, people are worried about where the price of oil will go. Some people are suggesting that oil could touch $220 a barrel. If that were to happen, there would be major inflation around the world. With fuel prices rising, nothing would be spared because the entire transport sector would be badly hit.

2)      Economic depression: The other major reason currently for inflation is the continuing economic depression. While the US and Western Europe are slowly emerging from the worst period of the recent recession, there is no certainty about the strength of their recovery. The un-employment rate in the US continues to hover around the 9% mark and this indicates that the US economy may not be as strong as we sometimes think it is. Likewise, Japan has been in trouble for a long time. Now with China planning to regulate its growth to 7% over the next 5 years, it looks that the world might not see a boom period for some more years.

3)      Easy money policies: The third major reason for the Dollar in particular to devalue is the easy money policy the US treasury (The Fed) is pursuing. Recently, it unleashed $600 billion of new currency in the market (in a policy called Quantitative Easing – 2)....basically, they just printed this much of new currency and put it out in the market. As a result, the value of the $ has come down (Incidentally, as a result of this, American investors started putting their Dollars into the stock market of India ....leading to a boom in the capital markets here in 2010).

4)      Political uncertainty: The fourth major reason for the price going up is that there is a perception of political uncertainty around the world. China is considered to be an inferno waiting to burst one day. India has seen political instability of late causing its stock market to lose steam. When the UK was forced to have a coalition government, things became really bad. And now with Obama on the back-foot and with the Congress and Senate split between the Democrats and Republicans, there is a clear worry that political uncertainty could be a big problem. Economics do not like uncertainty of any type.

5)      European financial crisis: With major European nations about to default on their sovereign debt (basically.....their own borrowings), investors were not comfortable putting their money in government bonds also. Entire nations in Europse have lost trust of investors....with the result that Gold has taken off.

What’s the forecast for Gold in the near future? Believe it or not, people are suggesting that it could double from here on and touch nearly $3000/oz in the next few years if things don’t improve. So Gold is still considered to be a great investment option.

The real truth is really a tease! Everyone knows that Indian women have stored tonnes and tonnes of gold in their households and their lockers. If the price of Gold escalates......it will again propel India towards even higher wealth. In the extreme scenario (and this is really an impossible scenario), if the usual currencies totally fail, and if Gold become the only currency, India will emerge as the  #1 country.....much earlier than the year 2050 that Citigroup suggested!