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Gold Rush – But Don’t !!!

Introduction

Gold and the US Dollar have a historic relationship from way back when the gold standard was being used. In 1900, the gold standard started and it ended in 1971. During the time of gold standard, the value of a currency was tied with the amount of gold held as reserves. In the gold standard regime, the relationship between gold and the US Dollar was strictly inverse. Post the regime the relationship is not as precise as it used to be, but whenever the value of the US Dollar decreases, gold prices rise.

In 2008, the IMF estimated that since 2002, around 40%-50% of the movement in gold prices is related to the US Dollar i.e. whenever there is a 1% change in the effective external value of US Dollar; the gold price will change by more than 1%.

Gold is generally considered as a protection against inflation. High inflation and negative real interest rates in a country have led to a rise in demand for gold. This is because when the real interest rate is negative, inflation eats up the value of financial investments. This was the case in India a few years back when RBI targeted WPI (Wholesale Price Index) as a general parameter for inflation, which was lower than CPI (Consumer Price Index) at that point in time.

Gold Rush - moneyHop
infographics credit: canva.com

Although US Dollar and International Gold prices have an inverse relationship i.e. whenever USD strengthens; international gold prices fell. Gold prices quoted in Indian Rupee also have an inverse relationship with Indian Rupee, which in a way means a direct relationship with USD. India is a trade deficit country i.e. the country imports more than the value of what it exports. On Indian Rupee depreciation, the value of imports rises, which directly impacts inflation as production costs rise. For example, a company in India that imports its production supplies from the US at an exchange rate of 74 USD/INR. In order to buy one unit of production supplies, the company will have to shell out INR 74. If US Dollar appreciates by 10% and USD/INR is traded at 81.40 USD/INR, at this level of US Dollar to Indian Rupee exchange rate the company will have to shell out INR 81.40 to import the same amount of production supplies, which means the production cost for the company has increased by 10%. This indicates an inverse correlation of INR external value with inflation and as the inflation rises the demand for gold increases. In India, 81% of gold demand comes from jewellery and investment and just 9% is used for industrial purposes. There is also a case when the US Dollar and Gold follow a direct relationship. This happens when there is a crisis in countries other than the US, which increases the demand for safe-haven assets.

From India’s point of view, a crisis occurred in mid-2013, when India’s macros were weak as CAD (Current Account Deficit) touched record high levels of 4.7% of GDP, GDP growth rate slowed down to sub 5% level and inflation was on a steep upward trajectory. The US economy on the other hand was showing signs of recovery and the Fed was planning to taper its quantitative easing program. Slowing of the Indian economy and recovery in US-led to flight to safety as investors were looking for safe-haven assets, which increased the value of gold and the US Dollar simultaneously.

In the recent past since the spread of the novel coronavirus disease (COVID-19), we have seen a surge in the prices of gold from ~48,000 USD/Kg (16th March, 2020) to around 66,000 USD/Kg (6th August, 2020) which is a 37.5% hike. One of the primary reasons for this run could have been the near-zero interest rates on Government bonds and high volatility in the stock market. These two factors might have driven the investors to a safe-haven asset such as gold.

It’s apt to say that gold is an important instrument of wealth accumulation in India, either directly (through investments in mutual funds tracking gold indices) or indirectly (through the purchase of jewellery or bullion). However, one should keep in mind that there are various factors affecting the price of gold such as the state of the economy, macro-economic conditions, geo-political stability, exchange rate fluctuations amongst many others which should be given due consideration before investing in gold.

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