--By Hom Nath Gaire

 

The price of yellow metal (gold) has fallen sharply by more than 25 per cent in the international market during last four consecutive business months.

And to be more precise it is the biggest drop in the last 35 years. Market study revealed that it has fallen approximately 30 per cent per ounce in 2013 only.

 

The steep fall in the gold price drew mixed reactions and different opinions among bullion experts, economists, buyers, central bankers as well as the bullion traders.

 

Some of them fear that the gold price will further go down in the near future citing the Cyprus crises, which is planning to sell off a huge gold reserve worth 400m Euros.

 

Not the least, the unanticipated slowdown in the Chinese economic growth, continuous improvements in the US markets and decline in demand from India drove the yellow metal to fall further to the worry.

 

A section of market experts have argued that the recent fall in gold price is not supported by the fundamentals rather it is the result of speculation in derivatives markets following the untested rumors and sparked declines across commodities. Hence they believed that the gold price will go up after the biggest plunge.

 

According them, the price of gold will be backed by good demand from physical investors, arbitrators and jewelers.

 

In June 15 analysts surveyed by Bloomberg expected that the gold prices will increase in near future. They have also researched experts view and analysts about the movement of gold price.

 

According to the Bombay Bullion Association (BBA) the gold price will go up as the Asian buyers have stepped up their purchase following its fall in terms of price, imports by India, which is the world’s biggest consumer. BBA expected that the demand for gold in India is likely to jump by 36 percent in the 2013.

 

However, Goldman Sachs Group, an American multinational investment banking firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients, predicted that the gold price may drop below USD 1000 per ounce within this year as the biggest hedge funds have reduced bets on gold at higher prices. Similarly, another school of thought argued that the investment on exchange-traded funds (ETFs) linked to gold have dropped by USD 37.2 billion in the first half of 2013, the fastest fall in last five years. In this back drop, they expected that the price of gold will further drop.

 

At the same time, central banks that hold large gold reserves are also divided in to two fractions fueling the controversy on gold price movement. The central bankers are also being the part of paradox whether gold is cheap enough to increase investment as the price is USD 750 cheaper per ounce since the record high in November, 2011.

 

The central bank of Sri Lanka and Scotland already said that the falling prices are an opportunity for nations to raise gold reserves. But the central banks of Korea and Australia said the plunge in gold price is not a big concern because gold has no intrinsic value and holding the yellow metal is part of a long-term strategy for diversifying currency reserves.

 

Likewise, Deutsche Bank said that the gold has entered a new reality and may reach as low as USD 1050 an ounce to bring its valuation back to the historical averages. The trend line draw from the USD 435 an ounce, average of 2005, also indicates that the inflation adjusted price of gold should now be hanging around the psychological level of USD 1000 per ounce.  

 

Regarding the determinants of gold price, various scholars have conducted scientific studies with well researched econometric models and attempted to draw conclusions about the determinants of the gold price. Traditionally, most of the empirical studies closes down to three major findings, which emerge with respect to the analysis of long-run determinants of gold price.

• First, there is a long-term relationship between the price of gold and the US inflation indicated by the consumer price index.

• Second, the global inflation and gold price move together in a statistically significant long-run relationship. This evidence substantiates the belief that gold is a long-term hedge against inflation.

• Third, an external shocks that causes a deviation from this long-term relationship and there is a slow reversion back towards it.

 

This means, although there is a possibility of seasonal variation as well as cyclical movement in the gold price in short and medium term, in the long run it will be guided by the global inflation in general and US inflation in particular.

 

In effect, the consequences of external shocks, there may be the deviation from the long-term relationship between the price of gold and the US inflation. This attracted the scholars and analyst to think beyond the long-run determinants and that the US economy as well as the USD is only the counterpart of the gold in international market. They attempted to analyze the short-run determinants of gold price taking other factors than US inflation and USD into consideration. Accordingly, the short-run analysis found that there is a positive relationship between gold price movements and changes in global interest rate along with major macroeconomic variables, US inflation volatility and credit as well as operation risk in the major financial markets of the world. 

 

 

Some other studies have revealed that there is a negative relationship between changes in the gold price and changes in the US dollar trade-weighted exchange rate against the major currencies, which are included in the basket of global reserve currencies. However, the findings reveal that the significant negative parameter on the “error correction mechanism” reflects the slow return of the gold price to its long-run relationship. These findings are in accordance with the theoretical framework put forward that the gold is safe haven for the versatile investors and one of the assets class for government and the central banks. Besides, there are some fundamentals of demand and of supply, which can influence the price of gold as in case of other commodities in perfect competition market.

 

However, some of the empirical studies reveal that there was no significant relationship between changes in gold price and its physical demand. Rather the price of gold has been driving by the virtual demand generated from the derivatives markets since there are hundreds times higher demand than that of the actual gold production across the world. Such artificial demand has especially been created by the speculators who want to mint money over the fluctuating price of any assets including gold. Every time they were trying to catch changes in gold price citing the change in world inflation, interest rate volatility, world income and the unproved rumors like central bank X is planning to sell this much of gold or huge gold reserve is identified in Y country etc.

 

Against these theoretical as well as hardnosed backgrounds, there is a major unresolved issue that gold is the most attractive as well as the most risky asset worldwide. The crucial question one may ask include — Is gold the long-run hedge of US inflation? If so, is that matters for countries other than the US? Was there positive relationship between the price of gold and the US inflation during the recent financial crisis when the US inflation was almost zero or negative in some quarters but gold price was breaking record high successively? These are the crucial questions that no study or school of thought can answer correctly.

 

But the fact is this is the glitter of gold and will remain same in the future as well.  

 

(Writer is Deputy Director at Confederation of Nepalese Industries (CNI) )