Analysis of GOLD Industry

Gold is a unique asset based on few basic characteristics. First, it is primarily a monetary asset, and partly a commodity. As much as two thirds of gold‟s total accumulated holdings relate to “store of value” considerations. Holdings in this category include the central bank reserves, private investments, and high-cartage jewelry bought primarily in developing countries as a vehicle for savings. Thus, gold is primarily a monetary asset. Less than one third of gold‟s total accumulated holdings can be considered a commodity, the jewelry bought in Western markets for adornment, and gold used in industry. The distinction between gold and commodities is important. Gold has maintained its value in after-inflation terms over the long run, while commodities have declined. Some analysts like to think of gold as a “currency without a country‟. It is an internationally recognized asset that is not dependent upon any government‟s promise to pay. This is an important feature when comparing gold to conventional diversifiers like T-bills or bonds, which unlike gold, do have counter-party risk.

What makes Gold different from other commodities?

The flow demand of commodities is driven primarily by exogenous variables that are subject to the business cycle, such as GDP or absorption. Consequently, one would expect that a sudden unanticipated increase in the demand for a given commodity that is not met by an immediate increase in supply should, all else being equal, drive the price of the commodity upwards. However, it is our contention that, in the case of gold, buffer stocks can be supplied with perfect

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elasticity. If this argument holds true, no such upward price pressure will be observed in the gold market in the presence of a positive demand shock.

The existence of a sophisticated liquid market in gold has, over the past 15 years, provided a mechanism for gold held by central banks and other major institutions to come back to the market. Although the demand for gold as an industrial input or as a final product (jewellery) differs across regions, it is argued that the core driver of the real price of gold is stock equilibrium rather than flow equilibrium. This is not to say that exogenous shifts in flow demand will have no influence at all on the price of gold, but rather that the large supply of inventory is likely to dampen any resultant spikes in price. The extent of this dampening effect depends on the gestation lag within which liquid inventories can be converted in industrial inputs.

In the gold industry such time lags are typically very short.

Gold has three crucial attributes that, combined, set it apart from other commodities: firstly, as said gold is homogeneous; secondly, gold is indestructible and fungible; and thirdly, the Inventory of aboveground stocks is astronomically large relative to changes in flow demand. One consequence of these attributes is a dramatic reduction in gestation lags, given low search costs and the well-developed leasing market. One would expect that the time required to convert bullion into producer inventory is short, relative to other commodities which may be less liquid and less homogenous than gold and may require longer time scales to extract and be converted into usable producer inventory, making them more vulnerable to cyclical price volatility. Of course, because of the variability of demand, the price responsiveness of each commodity will depend in part on precautionary inventory holding. The fundamental differences between gold and other financial assets and commodities give rise to the following “hard line” hypothesis: the impact of cyclical demand using as proxies GDP, inflation, nominal and real interest rates,

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and the term structure of interest rates on returns on gold, is negligible, in contrast to the impact of cyclical demand on other commodities and financial assets.

Global Scenario

Demand

Demand for gold is widely spread around the world. East Asia, the Indian sub-continent and the Middle East accounted for 72% of world demand in 2007. 55%

of demand is attributable to just five countries - India, Italy, Turkey, USA and China, each market driven by a different set of socio-economic and cultural factors. Rapid demographic and other socio-economic changes in many of the key consuming nations are also likely to produce new patterns of demand. This buying is likely to be centered in those countries where the investment element of the jewellery sector is strongest. The constraints surrounding mine output are unlikely to ease, and in fact, have the potential to worsen as credit conditions continue to cause problems for some miners and explorers. Furthermore, net selling by the central bank sector should remain at relatively low levels. However, as we saw in Q4, much will depend on the direction of the gold price and the scrap response.

Continued high levels of the gold price could see scrap levels increase further.

Table: Identifiable Gold Demand (tones)

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Jewellery

Gold jewellery demand declined during the fourth quarter as the global economic crisis began to bite and prices continued to fluctuate around relatively high levels.

Total tonnage off-take, at 538.9 tones, was down 6% on Q4 2007, while the year-on-year decline was a more marked 11%. Meanwhile, the $US value measure of demand reveals that Q4 demand of $US13.8bn was 4% below year-earlier levels, with the result that 2008 annual demand – at $US59.7bn – was 11% higher than 2007 levels.

The main factor affecting jewellery demand was the difficult economic environment that has taken hold in most countries. Consumers are facing issues such as rising unemployment and falling house prices and stock markets and are focusing their spending decisions on necessities. Once again however, it is worthy of comment that the value measure of jewellery demand confirms that spending on gold jewellery remains relatively robust. Although the severity of the economic climate took its toll in the fourth quarter, for calendar 2008 the primary value of gold jewellery demand increased by $US6.1bn. Movements in the price of gold were also a key factor in quashing demand. Although the gold price dipped sharply in October, it soon recovered lost ground and this higher price level, together with a rise in volatility, discouraged purchases in many of the more price sensitive markets. In contrast however, some markets, e.g. mainland China, Russia and the Middle East, benefited from elevated levels of investment-related demand for gold jewellery, as the intrinsic value of gold lent a stronger investment perspective to jewellery purchases. Industrial Electronics demand was profoundly affected by the global economic slowdown and subsequent lack of confidence across the supply chain, slipping 15%. Elsewhere, the other industrial and decorative sector recorded a modest 2% increase on the back of a significant rise in Indian off take, while gold

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used in dental applications continued its secular decline, falling 7%. Looking more closely at the electronics sector reveals an industry that, for the most part, is currently undergoing a crisis on the back of steadily deteriorating economic conditions. The decline of 15% relative to year-earlier levels took tonnage to its lowest level since Q4 2004. Waning consumer spending resulted in sharp declines in both production and exports from the world‟s largest producers. Demand from the other industrial and decorative segment was relatively stable Italy recorded a 6% rise relative to year-earlier levels as a result of increased GPC (gold potassium cyanide) production, much of which is used in the electro-forming of jewellery (a process geared to producing low weight jewellery items) and in the plating of accessories. Lastly, gold used in dental applications is estimated to have declined 7% relative to Q4 2007 as ongoing substitution to more affordable and cosmetically pleasing applications continued to limit the use of the precious metal.

Investment

Net retail investment drove the result, rising from 61.4 tons in Q4 2007 to 304.2 tons in Q4 2008 (an astonishing 243 tones or 396%) and accounting for 94% of the tonnage increase in identifiable investment. Net investment in Exchange Traded Funds (ETFs) and similar products also made a notable contribution to the increase in investor inflows, up 18% or 15 tones. All components of net retail investment recorded extremely strong growth. Bar hoarding, which largely covers the non-western markets, increased from 30.2 tonnes in Q4 2007 to 126.6 tonnes in Q4 2008, a rise of 318%? Official coins also enjoyed impressive growth, more than tripling from 22.4 tons to 67.9 tones. However, the highlight of the quarter was the 92.3 tone improvement in "other identified retail investment" to 92.6 tons from just 0.3tonnes. This category reflects the impact of “western” investor activity in the secondary retail investment market, predominantly Europe and North America i.e.

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it includes western demand for bars and secondary demand for official coins.

These dramatic retail investment inflows reflect the extreme uncertainty that surrounds the global economy and financial system. In an environment where investors are more concerned about the loss of capital than they are about the return on capital, the absence of default risk or counterparty risk has been a key attraction for gold Combining identifiable investment (largely investors with a medium and long term focus) with inferred investment (largely investors with a more speculative focus) gives us total investment flows. In Q4 2008, total investment was up 22% on the levels of Q4 2007. For the year as a whole, total investment was up 44%, equivalent to a 69% rise in $US value terms from $14.7bn to $24.8bn. These investment flows help explain why the gold price rose 25% from an average of $US695/ oz in 2007 to $US872 in 2008.

Notably, the annual increase in identifiable investment (which excludes speculative flows) exceeded that of total investment (which includes them). It is also clear that while those speculative flows were reasonably volatile on a quarter-to quarter basis, the main source of total investment flows during the quarter were, in fact, investors with a medium to longer term focus.

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Table : Identifiable Gold Demand ($USmn)

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Table : Investment demands (in tonnes except where specified)

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Table: Consumer demand in selected countries 2007 & 2008 (tonnes)

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Above table clearly shows that demand for gold in India is gradually decreasing because of very high price and also in India jewelry are made out of recycled or scrap gold. But we can find out that there is increasing in demand of gold from Greater china, China, Hong Kong and Vietnam. In Indonesia and USA there is tremendous increase for demand for net retail investment. Totally there is overall 3% increase in gold demand of gold but jewellery demand decreased 11% compare to 2007 and gold for net retail investment had reached 87% increase peoples are more interested keeping gold bars as asset.

Indian Scenario

India is the world‟s largest consumer of gold in tonnage terms. In 2005, India accounted for 22% of global gold jewellery demand and 35% of all net retail investment (coins and bars). Gold demand has grown at an average annual rate of 10% since the repeal of the Gold Control Act in 1990, which had forbidden the holding of gold in bar form1. Although estimates vary, India is now thought to hold close to 15,000 tons or 10% of the world‟s entire above-ground gold stocks.

Major Indian markets

Traditionally most investment has taken the form of physical gold. In 2005, Indians bought 102 tons of gold coins and bars. But there are new ways to invest in gold. Since October 2003 the government has allowed futures trading and there are now three futures exchanges, the two largest being the Multi Commodity Exchange of India Ltd (MCX) and the National Commodity and Derivatives Exchange Ltd (NCDEX). The next major development is likely to be the arrival of Exchange Traded Funds (ETFs), expected before the end of 2006. UTI Asset

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Management Company Ltd and Benchmark Asset Management Ltd are currently seeking regulatory approval to sell gold ETF. These instruments give investors a relatively cost efficient and secure way to access the gold market. They are listed securities that are backed by allocated gold held in a vault on behalf of investors and are intended to offer investors a means of participating in the gold bullion market without the necessity of taking physical delivery of gold, and to buy and sell that interest through the trading of a security on a regulated stock exchange.

Role of RBI in Gold

The Reserve Bank is required to hold a fixed amount of gold under the Reserve Bank of India Act. The original RBI Act (1934) obliged the Reserve Bank to hold 40% of its assets in gold coin, gold bullion and foreign securities, with not less than Rs. 400 million in value held in gold. The system was later amended, under the Reserve Bank of India Amendment Act 1956, to the minimum reserve system, that required the bank to hold at least Rs.1150 million of its assets in gold (this did not imply the need to acquire additional gold, as the value of existing goldreserves were revised up at the time). Rs.1150 million equates to just $24.7 million at today‟s exchange rate and is tiny in comparison to India‟s total foreign exchange reserves of $151.6 billion. India mobilized its gold reserves during the 1991 balance of payments crisis. Between May and July, India shipped a total of 47 tones of the country‟s gold reserves (the RBI is allowed to hold up to 15% of its total gold reserves outside the country) to the Bank of England as collateral against a $400 million loan and leased a further 20 tons of confiscated gold (not included in the reserve figures) to Union Bank of Switzerland with a six-month buyback option to raise a $200 million loan. The funds were used to help India meet its short-term debt obligations and import bill. The RBI bought back all 67 tons of gold later that year. It also revalued its gold reserves from Rs. 28 billion to Rs. 72

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billion, as it moved from using an outdated gold price4 to valuing its reserves at close to the international market price. The move vastly improved India‟s reported import coverage ratio. The RBI currently holds 557.7 tons of gold, which though small in comparison to total reserves (6.5% as at November 2009), is still the tenth highest of central banks in tonnage terms in the world.