Gold

Gold is increasingly viewed in two kinds of angles, by seriously literate people all over the world.

1. That there will be inflation, and thus, gold will be our savior.

2. There is no real safe currency anymore, so we must run to gold instead.

Either ways, Gold is being bought, so much that it saw a 30% rise in August alone. An ET article says that Indians and Chinese are buying a lot – institutional holdings abroad haven’t gone up.

And then, people argue that moving to a Gold standard will cause deflation, because as gold prices go up, the price of everything else in gold terms goes down.

My view: Yes, a gold standard will cause deflation. Why? Because gold supplies are limited, today. At some point, there will be a need to go find gold, and then, supplies will increase. But to understand why a gold standard is deflationary, consider this:

a) There is just 100 grams of Gold in the world, which let’s say is Rs. 200,000. That is now all the currency that’s around, you can’t increase it without adding more gold on.

b) This 200,000 is lent to a guy manufacturing mobile phones, who’s currently making, say 100 phones a year. People only use phones, so they pay Rs. 2,000 per phone. (Hey, imaginary world)

c) With an increase in productivity, he’s able to make 100 more phones this year The total amount of money around is Rs. 200,000, now distributed over 200 phones – so the phone price falls to Rs. 1,000.

This is simplistic economics – things don’t usually work exactly this way but it’s the gist of the story.

The one way to counter a “productivity improvement” is to debase your currency a little. Imagine that the RBI then issued 200,000 more rupees, for a total currency issued of Rs. 400,000. So now the 200 phones will still cost Rs. 2,000 each. But issuing more currency against the same gold is what is not allowed in a gold standard. This is why the gold standard is deflationary.

But the argument is also that deflation isn’t necessarily bad. Krugman argues that deflation will make people hoard money instead of spending it. But that’s not quite true; prices of electronics have kept falling, and people still buy electronics. And it’s not all obsolescence; my desktop computer is a 2007 model that works just fine today. People use more when the price is lesser.

But it’s different for a debt economy – if I can’t increase the amount of money I receive for my goods, I can’t pay interest on my borrowings. Will a bank lend me money for no interest? Banks borrow from depositors at some interest rate, and lend at a higher one and make the spread; with deflation, there is no spread. Banks, therefore, will fail in their current “highly leveraged” form. Reduce the leverage, and things work out much better.

Deflation is a problem for a leveraged system (which is why banks are scared of it) and I think if we need to survive as a society, we need less leverage, not more; and that necessarily means that highly leveraged systems should cut themselves down to size, or die.

But the Gold standard is dangerous because it puts artificial constraints linked to the availability of a metal. You must be able to tweak things a little, this way or that. Instead, we could have limits on how much our country is allowed to debase its currency. If the RBI wants 4% inflation, like it has targeted recently, it should only debase the base currency by 4%. As recently as last week, it had increased the supply of base money by 15% year on year. When you have an irresponsible debasing of currency, you will have an irrational attraction towards other stores of value.

How can the RBI stop the debasement? Just sell the assets it has, for rupees, and take those rupees out of circulation. It could sell the dollars it owns, the gold it has, the government debt it owns – anything – and easily keep the monetary supply growth below 4%. But when they choose not to do that and choose to raise rates instead, is it a wonder that many of us find gold as the answer?

RBI just hurt Gold Loan companies who had big advertisements on TV and Radio (Mannapuram, Muthoot).

From Moneycontrol:

The RBI is keen that banks lend more to the agricultural sector. That is the reason why it has said that only direct loans given with gold as collateral, will be treated as priority sector loans. Loans to non-banking financial company NBFC or gold-loan companies for on-lending do not count. But this move will mean that gold-loan companies lose a major source of funds.

M Narendra, CMD, Indian Overseas Bank says, “If they are not provided funds by the banks, like you have seen in microfinance institutions (MFIs). They may have to look for their own capital or go for equity so that they continue to be in the business.”

Estimates peg the gold-loan market at around Rs 50,000-53,000 crore and 30% of this comes from NBFCs like Muthoot and Manappuram. But given that 75% of their funding comes from banks, growth in this sector is set to take a huge hit.

Rupa Kudva, MD, CRISIL says, “One fallout of the new regulation is likely to be moderation in growth rates. These are companies which have seen growth rate of 70-75% and we expect that growth rate will moderate to become anywhere between 40-50%.”

The point is not to curb the lending, but to remove it from the priority sector (which needs to be 40% of bank lending, and therefore gets a better interest rate). There is definitely no reason to give gold-backed lending a priority status anyway (it still holds such a status, if the banks do it directly).

NSE is introducing Futures and Options on the Gold ETF – GOLDBEES – from April 30. This is quite interesting because no commodity has options on them in India, so in a way this is a first. If you are long Gold, for instance, and are only minorly bullish on it, you might write an out-of-the-money call to earn some income on your holding. Or if you’re slightly bearish you could write a credit call spread – write a lower strike call and buy a higher strike call – which indicates you don’t think the stock will go up too down, probably a little down. If volatility looks rich, you might write strangles or straddles, or use puts to buy insurance if prices go down.Options can be used to reduce risk in all sorts of ways – as it can be to use very high leverage to speculate.

The problem I see is in the strike prices – while there will be 21 strikes, they are separated by a distance of 10 rupees. That’s not much, especially if Gold becomes very volatile. Secondly, there is an expiry day difference – while F&O contracts in stocks trade upto the expiry day (the last thursday of the month), Gold Futures and Options will only trade till one day before expiry. I’m not sure what that means – is the settlement going to be the closing price on expiry day? (i.e. one full day of no trading but prices move in the spot market?) It seems so under the clearing rules. That’s one day of keeping positions open without the ability to hedge appropriately – not desirable.

The lot size is 125 units, which is 125 grams of gold, or about 2 lakhs gross exposure per contract.

Now the RBI is paying hard cash for the gold, meaning they won't pay using IMF Special Drawing Rights or any such. There's speculation that the RBI sold US T-Bills to pay for it. Which causes people to think the US will get all jittery because oh my god, people are running away from the dollar!

That is just silly.

India has 280 billion dollars of reserves. This $7 billion deal is like a drop in the ocean. There are not that many 200 ton deals to go around, and we can't diversify enough using gold, and if we tried too hard every country will do it and drive the price of gold to crazy levels.

Which is good for my son's education fund. But I digress.

Gold is around 6% of our total forex reserves - less than $15 billion. That the RBI is buying is interesting but only on influencing sentiment. There is simply no way to diversify the $280 billion easily. China's got about 3 times our Gold reserves, and has been stockpiling commodities for a long time. Still, that doesn't make a dent on their dollar dependance.

So it might be just posturing. With the US Fed saying things like "Exceptionally low rates for extended periods of time", there is probably a fear that the dollar will be toilet paper except toilet paper is cleaner. This could be a signal that more of such measures will be taken. But the US will be hardly bothered about a piddly 7 billion - in fact they'll probably not be bothered until it's too late. In the interim, it's better to do larger diversifications (set up infra funds using the reserves, buy different currencies, lend money to companies here and buy lots of companies abroad).

Gold, though, is an interesting interim play. I'll stay long on it for a bit.

It's an excellent compendium of links, articles and opinion on Gold. Some points:

• Gold, considered a hedge against inflation, does well in deflationary environments too. And if the environment involves devaluing currencies it goes up - like the purchasing power of gold did during the Great Depression and in the last 10 years.
• There's some evidence that while gold loses some sheen in the early part of a deflationary period, it climbs in the later part; the Yen-Gold chart is provided.
• Short term interest rates near 0% are good for gold.
• Government distrust - of the type happening in the US (we in India have never trusted our governments) - is positive for Gold.
• It's the currency-of-last-resort, so panics induce buying.
• China will buy dips and effectively put a floor on gold prices.

The International Monetary Fund has approved a sale of 403 metric tonnes of gold reserves, in a move likely to raise $13bn (£8bn) of cash to replenish its coffers for lending to low-income countries hit by the global economic downturn. The sale amounts to roughly an eighth of the institution's stockpile of the precious metal and comes as gold prices hit record highs, boosted by investors seeking safety away from volatile stockmarkets.

China is thinking of buying from the IMF. Given the 2.2 trillion of the increasingly value-losing dollar reserve, China needs a hedge or a way out. They say they'll only buy at a big discount, but it's not a big deal: the $13 bn this will generate for the IMF will not do much to diversify the reserves. Given the $10-15 billion in gold traded per day, they wouldn't be able to get a lot of gold out from the real markets even if they wanted, and that would really drive up prices. China's diversification strategy includes commodities of all sorts - they have stockpiled everything from iron ore to aluminium and copper. Still, nothing that can make a serious dent on the $2.2 trillion they hold.

India might also pitch in - and try to buy a part of this to keep the $280bn of reserves in gold (only $10 bn is currently in gold).

What this will do is temporarily set up a floor price on gold, as a good friend told me yesterday. Gold just crossed $1000 an ounce, and in India trades at 1600 rupees a gram (though Goldbees, the ETF, trades at 1575).

The total amount of gold ever mined is the order of 150K tonnes. That at $1000 an ounces is about $4.5 trillion. To give you context, the amount of money in print in just the US is about $8.3 trillion. It's unlikely that this precious metal will be able to hedge dollar exposure very much, but you can bet that some countries are going to give it a shot.