Opinion The fall of gold

The reasons why gold prices are unlikely to stage a dramatic recovery,at least in the foreseeable future,are to be found in the very factors that led to the surge in its prices in the first place. Gold has historically been held as a hedge against economic uncertainty and inflation. The 2008 financial crisis and the turmoil that followed sent investors scurrying for the “safety” that gold offered,bidding prices up sharply in the process. For economies like India,which incidentally was a major contributor to global gold demand (in 2011-12 it imported 800 tonnes),it was the spectre of rising inflation that tilted household portfolios in favour of gold. Both these risks have dissipated.

It is true that pockets of potential financial stress remain,particularly in the eurozone’s periphery. The Cyprus imbroglio was perhaps a wake-up call that reminded us that risks still linger in the global financial system. That said,the possibility of a full-blown crisis has certainly waned. This is partly the result of structural improvements in these economies (current account deficits have improved for instance) and risk-mitigation policies like the European Central Bank’s Open Market Transactions (OMT) policy. If the risk of financial implosion has waned,a moderation in the demand for “a safe-haven asset” should naturally follow. The correction in gold prices is a reflection of this.

Global and domestic inflation is also softening. Aggregate global inflation is likely to be 3.8 per cent,a tad lower than last year. In India,where the inflation-gold demand link has been the strongest,there are the initial signs of what could be a sustained decline in inflation. Thus,the appetite for gold as an inflation hedge is also diminishing.

There are a couple of other specific risks. Cyprus had to sell 400 million euros from its gold reserves to tide over its crisis,raising fears that gold reserve sales by central banks would be part of the banking/fiscal crisis resolution mechanism. This could entail a large quantum of gold supply from European central banks if larger economies like Italy and Spain were to face stress. Also,there is an increasing risk of the US Fed winding down its quantitative easing programme in the second half of 2013. As fewer dollars are printed,this would be positive for the US dollar and negative for gold.

However,gold is not the only commodity whose prices have come under pressure. The CRB metals index,a composite index of traded metals,showed a decline of 9 per cent between February and April this year. Unlike gold,metals are not a store of value but reflect expectations of economic conditions. These markets are now coming around to the view that going forward,global growth is likely to remain tepid and liquidity infusion alone cannot justify the kind of valuations they fetched. The fact that Europe is stuck in the doldrums has been recognised by the markets for a while now. What seems to have spooked the markets now is the fact that after showing tentative signs of revival in the last quarter of 2012,China seems to be faltering again. Its growth in the first quarter of 2013 was a disappointing 7.7 per cent and there is a risk of further deceleration. India would be lucky to get to 6 per cent. For the emerging markets as a whole,growth is likely to be a paltry 5.1-5.3 per cent this year. To put things in perspective,in 2007,emerging markets grew by 8.8 per cent. The upshot is that emerging market demand is unlikely to pick up the slack from Europe and other developed markets.

While the prospect of subdued global growth has kept commodity prices under a lid there is an additional development that could keep energy prices especially soft going ahead. Better extraction technology through means such as fracking and horizontal drilling in the US has expanded the supply of shale gas and oil,and has reduced their cost of production. Increased supply of shale has pushed global gas prices lower and has meant that the contribution of shale gas to the total natural gas requirement of the US has gone up from a mere 1 per cent in 2000 to 25 per cent in 2012. Together with increased shale oil production,this has meant greater energy self-sufficiency for the US,which has helped the country meet 84 per cent of its energy needs in 2012.

While increased shale oil production has had only a modest impact on global oil prices,given its small share in global oil supply,the real drag on oil prices is likely to come from the increasing substitution of relatively more expensive crude oil with shale gas as a primary energy source. Some of this shift in the energy mix is already visible in the US with shale gas slowly replacing oil as an energy source in several areas such as petrochemicals manufacturing,heat generation and railways. With the development of technology,it is likely that this shift in the energy mix of the US could be replicated across the world,taking the pressure off global oil demand and pushing oil prices lower.

The salutary impact of falling global commodity prices has been the most apparent in countries that are large net importers of commodities like India. Falling gold prices and reduced investment for gold could mean a substantial reduction in the gold import bill,even if lower prices were to encourage some rise in jewellery demand. It is quite possible that the import bill settles in the $40 billion ballpark in 2013-14 instead of $50 billion for 2012-13. That’s a straight reduction of 0.5 per cent of GDP in the current account deficit.

There are also other effects that could sustain. With the commodity intensity of the manufactured goods basket of the WPI at 40 per cent,the global commodity price moderation has (along with weak domestic demand) pulled manufactured goods inflation lower from 6.4 per cent in August 2012 to 4.1per cent in March 2013. There could be a further reduction going forward. Taking the effects of softer industrial commodity,oil and gold prices,it is possible to forecast the current account gap at a good 0.7-1.2 per cent of GDP lower for 2013-14 than its level of 5 per cent that is estimated for 2012-13. Needless to say,lower commodity prices,oil in particular,are likely to mean that the pressure on the subsidy bill and the fisc could also abate. While these developments could themselves support domestic growth in the year ahead,the prospect of narrower macro imbalances and lower inflation as a result of softer global commodity prices could also enhance the window for policy responses by the RBI and the government to address current growth concerns.

The writer is chief executive officer of HDFC Bank

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