bullion strategy

8/3/2019 Bullion Strategy

1/30

c Q ( b~fJPPFAS

fromFinancial Planning Division

Bullion Strategy


2/30


3/30

Bullion Strategy

Index

Introduction to Gold Page 1

Introduction to Silver Page 6

Gold as an Asset Class Page 9

Commodities and Its Various Factors Page 11

Economic Cycle and The Returns from the Commodities Page 13

Inflation and Gold Page 15

Gold or Oil, which is better predictor of Inflation Page 17

Why Gold is different from other assets Page 20

Value of Gold Page 23


4/30


5/30

price and US macroeconomic and financial marketquarterly data from January 1975 to December2001, the following conclusions may bedrawn:

There is no statistically significant correlationbetween returns on gold and changes inmacroeconomic variables, such as GOP, inflation andinterest rates; whereas returns on other financialassets, such as the Dow Jones Industrial Average,Standard & Poor's 500 index and 10-yeargovernment bonds, are highly correlated withchanges inmacroeconomic variables.

Macroeconomic variables have a muchstronger impact on other commodities (such asaluminum, oil and zinc) than they doon gold.

Returns on gold are less correlated withequity and bond indices than are returns on othercommodities. Assets that are not correlated withmainstream financial assets are valuable when itcomes to managing portfolio risk. This researchestablishes a theoretical underpinning for theabsence of a relationship that has been demonstratedempirically for a number of years; namely, thatbetween returns on gold and those on other financialassets.

Today's gold market is a round-the-world,round-the-clock business, played out largely ondealers' trading screens. The core of the business,however, remains in the key markets of London, asthe great clearing house, New York as the home offutures trading, Zurich as a physical turntable,Istanbul, Dubai, Singapore and Hong Kong asdoorways to important consuming regions andTokyo where the Commodity Exchange (TOCOM)sets the mood of Japan. Even Paris still has a smallmarket, a reminder of the days when the French weregreat hoarders, while Mumbai has increasingimportance under India's liberalised gold regime thatpermits official imports through local markets.

According to Gold Field Mineral Services,world gold output in 2001 was 2,604 tons,moderately higher than 2,584 ton in 2000. Totalproduction throughout history topped 142,500metric tons by the end of 2001. South Africa is theworld's largest gold producer, with 393.7 tons in2001, according to the Chamber of Mines. From1884 through 2001 it has produced nearly 49,000

Bullion Strategy: Introduction to Gold

tons, which is around 35% of all gold ever mined. Nochallenger is in sight or likely to be inthe foreseeablefuture. The United States is the second-largest gold-producing nation in the world. Most of this gold isproduced in western states such as Nevada, whichproduces more gold than any other state. Australia isthe world's third largest producer of gold with outputof 285.0 tons in 2001 a decline of 4% from 296.4tons in 2000. Gold Fields Mineral Services Ltdestimate the above-ground stocks of gold to havebeen some 145,200 tons at the end of 2001 , afigurethat dwarfs annual new mined supply of around2,600 tons. Much of this is held in a form that canreadily come back to the market under the rightconditions. This is obviously true for investmentforms of gold but it is also true for much jewellery inAsia and the Middle East. In these regions jewellerytraditionally fulfills a dual role, both as a means ofadornment and as a means of savings. Notably, it isparticularly important for women in Muslim andHindu cultures where traditionally a woman'sjewellery was often in practice her only financialasset. Consumers arevery aware of price movementsand very sensitive to them. Gold will be sold in timesof financial need but holders will frequently takeprofits and sell gold back to the market if the pricerises. Thus the supply of scrap gold will normallyautomatically rise if the gold price rises. Even goldused for industrial purposes such as electricalcontacts in electronic equipment is frequentlyrecovered as scrap and a rise in the gold price willincrease the incentive for such recovery.

India is the world's largest consumer of gold.According to Gold Field Minerals Service, in 2001 itabsorbed around 700 tons from the world market,compared to just 320 tons in 1994; that is withouttaking into account the recycling of scrap from theimmense stock of close to 10,000 tons built up on thesub-continent in the last few hundred years, or goldimported for jewellery manufacture and re-export. Anhistorical perspective is useful in understanding whyIndia has been for so long, and still is, a great marketfor gold and also for silver. India, the saying goes,has always been 'a sink for precious metals'. Bothmetals are closely woven into the social fabric,especially in the rural areas where they are the basicform of saving. In recent times India has remainedfaithful to gold. While demand has increasedsubstantially since the early 1980s due to generaleconomic growth, annual consumption is dictated

2


6/30

both by the monsoon, with its effect on the harvest,and the marriage season. In an auspicious year thereare upwards of ten million marriages, at whichbetween 20 and 200 grams may be worn by thebride. The status of a family in its community is stilloften judged by the gold exchanged as the bride'sdowry. The official import of gold into India,however, was banned from 1947. The Gold ControlAct of 1962 also forbade private holding of gold bars.With local production of less than two tons from twosmall mines, Bharat and Hutti, together withrecycling, the main demand was met by smugglingfrom the regional markets of Oubai, Singapore, andHong Kong, usually as ten tola bars, uniquelypreferred in India. The smuggling was a highlyprofessional business, involving up to 200 tons,encouraged by a premium of 30 per cent over theLondon price. Over 3,000 tons has entered Indiaunofficially since 1947.ln the 1990s, however,deregulation of the market has finally taken place,ushering inthe modern market of today. Since 1990,investment insmall bars, both imported ten tolas andlocally-made small bars, which have proliferated fromlocal refineries, has increased substantially.Estimates vary, but it is believed that at least 13,000tons of gold rest in India or approximately nine percent of the world's cumulative mine production. Thisshould beviewed against our share in land area at 2.4per cent, in population at 16.4 per cent and in GOPat1.2 per cent. Mining and production of gold in India isnegligible, now placed around 2 tons as against atotal world production of about 2,272 tons in 1995.During 1990-95, India's share in global gold demandis placed at about 402 tons (16.4 per cent) a year,including imports into India. This should be viewedagainst its share of 0.6 per cent inworld trade. Ontheother hand, India exported about 23 tons in 1995accounting for a negligible part of world trade. Of thetotal gold reserves estimated to be on the books ofthe Central Banks (subject to some Banks notdeclaring them) of 28,225.4 tons, the holdings ofReserve Bank of India are only a modest 397.5 tons.Government of India has in its possession someamount of gold mainly out of confiscation ofsmuggled gold remaining after transferring it to theReserveBank of India from time to time. RBIis neithera speaking purchaser nor a seller of gold reserves,unlike many other countries including somedeveloping economies, especially in Asia. A part ofgold was used by RBI (in parallel with gold withGovernment) for raising foreign currency resources


during the balance of payments crisis in the early'nineties. These overseas gold holdings are beingused as part of reserve management to yield a return.Use of gold as a financial product is virtually non-existent in India except to a limited extent of issuing'Gold Bonds' by Government of India from time totime coupled with occasional tax amnesty.

Gold is valued in India as a savings andinvestment vehicle and is the second preferredinvestment behind bank deposits. India is the world'slargest consumer of gold in jewellery (much of whichis purchased as investment). Indian people arerenowned for saving for the future and the financialsavings ratio is strong, with a ratio of financial assets-to-GOP of 93%.Gold's circulates within the systemand roughly 30% of gold jewellery fabrication is fromrecycled pieces. In 1998-2001 inclusive, annualIndian demand for gold in jewellery exceeded 600tons; in 2002, however, due to rising and volatileprices and apoor monsoon season, this dropped backto 490 tons, and coin and bar demand dropped to 67tons. Indian jewellery offtake is sensitive to priceincreases and even more so to volatility. Typically,India accounts for 20% of global gold offtake in anyone year. Its GOP (as measured by the World Bank) in2001 was 1.5% of the world's total. It was notalways thus. As recently as 1991, Indian golddemand was a little over 230 tons, or only 8% ofworld offtake. The deregulation of the market duringthe 1990s brought about a dramatic change.Jewellery demand increased from 208 tons in 1991to peak at 658 tons in 1998, while demand forinvestment bars grew from ten tons in 1991 to 116tons in 1998, and registered 85 tons in 2002. Thesefigures reflect average growth rates of 16% and 30%per annum respectively between 1991 and 1998.

The gold mining industry today is a globalbusiness in every sense, conducted in over 60countries, of which 16 have significant output of over31.1 tons (1 million oz}, and which is dominatedincreasingly by international mining groups. Yet just20 years ago, it was a business dominated by theoutput of South Africa and the Soviet Union andundertaken mainly by local mining companies (albeitlarge ones in South Africa). This transformation is asradical as any in the history of the industry. Goldmining is very capital intensive, particularly in thedeep mines of South Africa where mining is carriedout at depths of 3000 meters and proposals to mine

3


7/30

even deeper at 4,500 meters are being pursued.Typical mining costs are US $238/troy ounce goldaverage but these can vary widely depending onmining type and ore quality. Richer ores mined at thesurface (open cast mining) is considerably cheaper tomine than underground mining at depth. Such miningrequires expensive sinking of shafts deep into theground. Gold exploration budgets have fallen sharplysince 1997. In that year miners spent US$2.99 billionon gold exploration; in 2001 the total was just lessthan US$850 million, a significant decline of over70%. Moreover, the total share of exploration forgold in all mining exploration worldwide has fallenfrom 65% to 38% in the same period, according toCanada's Metals Economics Group. Not only isexploration down, but some new projects are onhold.

India has been known to possess large stocksof gold and studies show that they are mostlyaccumulations from centuries of trading rather thanresult of production of her mines. What is ofcontemporary interest, however, relate to thedemand, supply and price-movements and their linkwith policy. Some broad generalizations on theseaspects would be appropriate to review the policyand identify the issues. First, on the demand side,while there are no authentic estimates, the availableindications are that about 80 per cent is for jewelleryfabrication (mainly of over 22 carat purity) fordomestic demand, 15 per cent is for investor-demand(which is relatively elastic to gold-prices, real estateprices, financial markets, tax-policies, etc.) andbarely 5 per cent is for industrial uses. The annualconsumption of gold which was estimated at 65 tonsin 1982 has increased to 505 tons in 1995. Althoughit is likely that with prosperity and enlightenment,there may be deceleration in demand, particularly inurban areas, it would be made good by growingdemand on account of prosperity in rural areas. In thenear future, therefore, the annual demand willcontinue to be high at around 400 to 500 tons. Thereis reason to believe that a part of investment demandfor gold assets isout of black money.

A ORG study (Gold Mobilisation Instrumentas an External Adjustment) prepared in the RBI in1992, tested five factors for their influence ondemand for gold. These five factors are1.Generation of large market surplus in rural areas as


a result of all round increase in agriculturalproduction,2. Unaccounted income/wealth generated mainly inthe service sector,3. Comparative rate of return available on alternativefinancial assets like bank deposits, units of UTI, smallsaving schemes etc.,4. Pricevariation ingold and5. Priceof other commodities.

The study led to the conclusion that the firsttwo factors i.e. rural surplus and unaccountedincome in the service sector have far more influenceon gold demand than the other factors. In anotheranalysis made by Shri Vaidyanathan in 1999,(Economic and Political Weekly, February 20, 1999)the factors determining the demand for gold werestudied. The parameters taken into account wereGOP, ratio of household financial savings to nationalproduct, domestic price of gold, GOPdeflator, indexof ordinary share prices and the difference betweendomestic and foreign price of gold as percentage ofinternational prices. The study established that goldimports tend to be higher when domestic gold pricesrise relative to those of ordinary shares andinternational gold prices; but, the effect of these twovariables was pronounced during 1991-96 ascompared to 1970-90. Dr. Saumitra Chaudhuri(Financial Express, November 26, 2001) made ananalysis of the possible choices for a saver betweeninterest bearing financial instruments and gold. Headvocates that in Indian conditions, a return of lessthan 6 per cent for a saving instrument would inducethe saver to invest ingold.

Different reasons for investing inGOLD.Existence of a Huge and Growing Gap between MineSupply and Traditional Demand:Gold mine supply is roughly 2500 tonnes per annumand traditional demand (jewellery, industrial users,etc.) has exceeded this by aconsiderable margin for anumber of years. Some of this gap has been filled byrecycled scrap but central bank gold has been the

4


8/30

primary source of above-ground supply.Mine Supply is Anticipated to Decline in the nextThree to Four Years:

Even if traditional demand continues to erode due toongoing worldwide economic weakness, the supplydemand imbalance is expected to persist due to adecline in mine supply. Mine supply will contract inthe next several years, irrespective of gold prices,due to a dearth of exploration in the post Bre-X era, ashift away from high grading which was necessaryfor survival in the sub-economic gold priceenvironment of the past five years and the naturalexhaustion of existing mines.Investment Demand for Gold is Accelerating:When the crowd recognizes what is unfolding, theywill seek an alternative to paper currencies andfinancial assets and this will create an enormousinvestment demand for gold. To facilitate thisdemand, a number of new vehicles like Central GoldTrust and gold Exchange Traded Funds (Elf's) arebeing created.Alarming Financial Deterioration inthe US:In the space of two years, the federal governmentbudget surplus has been transformed into a yawningdeficit, which will persist as far as the eye can see. Atthe same time, the current account deficit hasreached levels which have portended currencycollapse invirtually every other instance in history.Global Currency Debasement:The US dollar is fundamentally & technically veryweak and should fall dramatically. However, othercountries are very reluctant to see their currenciesappreciate and are resisting the fall of the US dollar.Thus, we are in the early stages of a massive globalcurrency debasement, which will see tangibles, andmost particularly gold, risesignificantly inprice.The Central Banks are Nearing an Inflection Pointwhen they will be Reluctant to Provide more Gold tothe Market:The central banks have supplied too much already viathe leasing mechanism. In addition, Far Eastern


central banks who are accumulating enormousquantities of US dollars are rumored to be buyers ofgold to diversify away from the USdollar.Gold is Increasing in Popularity:Gold is seen inamuch more positive light incountriesbeginning to come to the forefront on the worldscene. Prominent developing countries such asChina, India and Russiahave been accumulating gold.In fact, China with its 1.3 billion people recentlyestablished a National Gold Exchange and relaxedcontrol over the asset. Demand in China is expectedto rise sharply and could reach 500 tonnes inthe nextfew years.Rising Geopolitical Tensions:The deteriorating conditions in the Middle East, theUSoccupation of Iraq, the nuclear ambitions of NorthKorea and the growing conflict between the US andChina due to China's refusal to allow its currency toappreciate against the US dollar headline thegeopolitical issues, which could explode at anytime.A fearful public has a tendency to gravitate towardsgold.Limited Size of the Total Gold Market ProvidesTremendous Leverage:All the physical gold in existence is worth somewhatmore than $1 trillion US dollars while the value of allthe publicly traded gold companies inthe world is lessthan $100 billion USdollars. When the fundamentalsultimately encourage astrong flow of capital towardsgold and gold equities, the trillions upon trillionsworth of paper money could propel both tounfathomably high levels.

5


9/30

Introduction To SilverSilver has been a multifaceted asset

throughout history. It was found as a free metal andeasily worked into useful shapes and was widelyused by early man. The beauty, weight and lack ofcorrosion made silver a store of value, and hence oneof the earliest of metals to be used as a medium ofexchange. The early discovery that water, wine, milkand vinegar stayed pure longer insilver vessels, led toits desirability as a container for long voyages.Sparkling tableware, shining jewelry, and livingspaces brightened by silvered mirrors arethe obviouscontributions of silver to our daily lives. It is,however, the silver behind the scenes that makes ourmodern world function efficiently. Inside switches,silver contacts efficiently and safely turn on and offthe powerful electric current that flows into ourhomes, our lamps and our appliances. It is silverunder the keys of computer keyboards, behindautomobile dashboards, and behind the controlpanels of washing machines or microwave ovens thatswitch on or off at the touch of the finger. And insidethe 220-volt line circuit breaker boxes inour homes orinside the 75,000-volt circuit breakers in powerstations, silver performs a safe and steady task ofswitching on or off our most dependable servant,electric power, throughout our lives. Thus it becomesimportant to understand the basics of this commoditylike it's past-present and it's demand supply andvarious factors.

Bullion Strategy: Introduction to Silver

Based on the Analysis of available literatureand historical records, the production levels from 300B.C. to 1000 A.D. are not likely to have risensignificantly from the estimated 1.5 million troyounces per year levels of the Laurium mine era.Although mine production in Spain dominated thefirst 1,000 years A. D., it was balanced by the declinein production at Laurium and Asia Minor. The realexpansion in production occurred in the 500-yearperiod from 1000-1500 A.D., when the number ofmining locations and, to a lesser extent, theimprovements in mining and processing technologyoccurred. From 1500 through 1800, Bolivia, Peruand Mexico accounted for over 85 percent of worldproduction and trade. The remaining production inthe period was derived largely from Germany,Hungary, and Russia, with lesser amounts from otherEuropean countries, Chile, and Japan. After 1850,several other countries increased productionparticularly the United States with its discovery ofthe Comstock Lode in Nevada. Silver productioncontinued worldwide, growing from 40 to 80 milliontroy ounces annually by the 1870s.

Demand for silver is built on three mainpillars; industrial uses, photography and jewelry &silverware. These accounted respectively for 40%,24% and 30% of demand in 2002. Together, thesethree categories represent more than 95 percent ofannual silver consumption. In 2002, 342 millionounces of silver were used for industrial applications,while over 205 million ounces of silver werecommitted to the photographic sector, and 259million ounces were consumed in the jewelry andsilverware markets. Today, the demands of moderntechnology have revealed the remarkable range ofelectrical, mechanical, optical, and medicinalproperties that have placed silver as the key metal inmany applications.

World mine production is more a function ofthe prices of other metals. Often a faster growth indemand against supply leads to drop in stocks withgovernment and investors as Silver demand standson three pillers jewellery & silverware, industrial andphotography, which are in turn factors of monsoon &agricultural output - overall industrial growth andperformance of the tourism & services industry atlarge, respectively. In recent years India has seenincreased imports from China both in the legal andillegal route via Hong Kong. In India the inter-state

6


10/30

disparity in sales tax and octroi on imported silver ( inthe past ) gave a huge scope of leverage to thedomestic players. In India the real industrial demandoccupies a small share in the total industrial demandof silver in sharp contrast to most developedeconomy's like Japan and US. In India like Gold theSilver demand is also determined to a large extent byits price level and volatility.

Silver supply is derived from two sources-new mine production and existing above - groundstocks of bullion and fabricated products. In 2002,some 30% of the market's requirements equivalentto around 7,840 tons were met by recycled above-ground stocks, the balance being provided by newlymined silver. Mine production is unsurprisingly thelargest component of silver supply. It normallyaccounts for a little under two-thirds of the total.Geographically, just over half of mined silver comesfrom the Americas with Mexico, Peru and the UnitedStates, respectively, the first, second and fourthlargest producing countries. The third largest isAustralia. Of greater market relevance, however, isthe type of mine that silver comes from - most silveremerges as a by-product of the mining of othermetals. A much more comes from lead/zinc mines.Primary mines produce about 27 percent of worldsilver, while around 73 percent comes as a by-product of gold, copper, lead, and zinc mining. This isimportant, as the price of silver will only have adirectimpact on primary output, which means the amountof silver mined is more a function of the price of othermetals. Old scrap normally makes up around a fifth ofsupply Scrap, or more properly, "old scrap", is thesilver that returns to the market when recovered fromexisting manufactured goods or waste. This couldinclude old jewelry, photographic chemicals, evendiscarded computers. Disinvestment andgovernment sales are similar in that as both comprisethe return to the market of old coins or barsrespectively by the private sector or governments.The final, though normally minor, component ofsupply is producer hedging or the early saleby miningcompanies of future production, a form of"accelerated supply".

The tie between silver and economic activityis strong, given that around two-thirds of total silverfabrication is in the industrial and photographicsectors. This differentiates silver from gold where anelement of investment is present in the purchase of


jewelry and bars (jewelry accounted for nearly 70%of total gold demand last year). Sluggish economicactivity inthe world's major economies had amaterialimpact on total fabrication offtake.

The bulk of the silver trade in India is actuallystill unofficial. For example, in the past, Mumbai inMaharashtra State used to attract around 80-90% ofIndian silver imports because it was the premierbullion trading centre and a predominant fabricationcentre as well. However, rising sales tax and octroi (alocal tax) in the state meant that most of the officialimports eventually shifted to low sales tax centersaround the country. The main beneficiary of this inthe early years was Ahmedabad with its low salestax, and at one time that city accounted for almost allof the silver (and gold) imports coming into India.However, since it was neither a major consuming normanufacturing center, most of the bullion importedwas smuggled into other states (for example, asubstantial portion of gold and silver imported intoAhmedabad eventually flowed into Mumbai illegally).Initially, the disparity in sales tax betweenAhmedabad and the rest of the country wassubstantial, which iswhy somuch metal was shippedvia that city. However, this changed dramaticallywhen Jaipur (in Rajasthan) introduced a new systemfor bullion imports, the so called'green channel'. Thissystem allowed traders or groups of traders to pay alump sum tax of Rs.2.5 crore against which theycould import as much gold as they liked. Theincentive was, of course, to import ever-higherquantities to reduce the effective marginal tax rate.Because of this inter-state tax arbitrage, attemptshave been made over the past few years to introduceuniform VAT (value added tax) throughout India.

India is one of the largest users of silver intheworld, ranking alongside those Industrial giants,Japan and the United States. The "other" category ofdemand in India covers a multitude of different enduse applications, ranging from foils for use in thedecorative covering of food to the plating of jewelryand silverware. One other very significant consumerof silver is jari. Jari is a thread used for saris andmostly is produced in Surat, Gujarat. It is a massiveindustry, utilizing avariety of materials which includegold and silver. "Real" jari is made of silver andelectroplated with gold and is a major status symbol.As might be expected, the consumption of jari is verymuch a function of how well the economy is doing

7


11/30

and how much people are earning. It will come as nosurprise then that GFMS (Gold Field Mineral ServicesLtd.) estimate for (2001 2002) year jari fabricationfell sharply, by around 18%, from 232 tons to 190tons due essentially to the weakness in theagricultural sector. The agricultural output in 2002fell by around 3% due to the poor rains whichadversely affected the kharif (summer) crop. Theweakness in the agricultural sector has also hadnegative implications for all of the "other" industrialuses in India. For example, GFMS estimate that foilfabrication collapsed in that year, although this wasdue to a combination of price, lower incomes and theban on gutkha (a tobacco based chewing productthat contains silver) in certain states. It has beensuggested in certain quarters that India actuallysuffered one of the worst droughts in 100 years in2002 and it seems reasonable to assume that thisadversely affected rural incomes, which in turn hadan impact on silver offtake (one needs to bear inmindthat these difficult economic circumstances weretaking place against the backdrop of high local silverprices) as farmers cut back sharply on their purchasesof "new" silver (there was also an offsetting rise inscrap, although this was very small compared withthe situation inthe gold market).

By contrast, fast growing sectors liketelecom, software and durable goods exports have allcontributed to strong "real" industrial demand (datareleased at the time of the 2003/04 budget pointed toindustrial production having risen 6.1 % (fiscal yearon- year) compared to just 3.3% the previous year).As a result, GFMS estimate thatelectronics/electrical, solders and brazing alloyofftake increased in (2002) year, by around 4 and 5%respectively. Although "real" industrial offtake inIndia is still relatively low, there is every indicationthat this is likely to grow in the future. For example,India already plays host to the third largest opticalmedia manufacturer in the world (the company hasbeen an original equipment manufacturer for Sonyand Samsung), which uses a substantial quantity ofsilver in various recording devices. The SouthKoreans also have a dominant presence in India and,increasingly, products are being made predominantlyfrom locally sourced materials (for example, LGclaims that its products have over 70% localizedcomponents and, in color televisions, this rises to95%). Price volatility is also an importantdeterminant of silver demand (as it isfor gold as well).


Consumers are particularly sensitive to changes inthe price and the oscillations throughout the yeardiscouraged demand for extended periods of time.

The received wisdom is that Indianconsumers will tend not to buy on an upward trend inprices, expecting them to fall. However, falling pricesare not necessarily a signal to buy either. Instead,potential purchasers hold back waiting for the price toreach what is perceived to be the low for the period,which can result in lengthy periods of slack demand.As most Indians in the industry will attest, as a rule ofthumb, price stability is crucial for demand to return.A primary factor affecting the price of silver is theavailable supply versus fabrication demand. In recentyears, fabrication demand has greatly outpaced mineproduction forcing market participants to draw downexisting stocks to meet demand. As these availablesources continue to decline, silver's fundamentalscontinue to strengthen. However, since silver is atangible asset, and is recognized as a store of value,its price can also be affected by changes in thingssuch as inflation (real or perceived), changing valuesof paper currencies, and fluctuations in deficits andinterest rates, to nameafew.

8


12/30

Gold As AnAsset ClassGold makes a good investment avenue for investorsinsearch for asafe haven and seek protection againstvolatile markets. Gold has gained strength asinvestors across most developed markets have takena fancy for gold as an investment avenue amidstconcerns over widening USbudget and trade deficit,high energy prices, rising terrorist concerns andvolatile financial asset prices. Investors have movedfrom financial assets to precious metals like gold,which has increased the demand for gold in theinternational financial market. During the year 2005,gold posted an average return of about 30%,compared to 36% generated by equities, 8% returnsoffered by government securities, 5.5-6 % earned onbank deposits. The less volatile nature along withcushion against inflation makes gold an attractiveinvestment avenue compared to equities. Gold hasrebounded from a 20 year bear market that beganwith awar on inflation in the 1980s and ended with awar on terrorism and a fiscal policy that is nowflooding the world with dollars. Gold was USD 35 anounce in 1970, peaked at USD 850 an ounce in 1980and from there to about USD 250 an ounce in 1999.Gold prices started firming up since April 03 andtouched a new 25 year high in Jauary 06 when gold

BullionStrategy: Gold as anAsset Class

for immediate delivery touched USD 571 an ouncehighest level since January 1981 .What Lead ToA Boom InGold Prices?

1. Central bankers who have been net sellers of goldfor the past 40 years have shown sudden interest inraising their gold reserves. In the London BullionMarket Conference, several representatives ofCentral Banks have advocated a low sell strategy infuture. Russia is planning to double its reserves ingold and South Africa also signaled an increase in itsgold reserves. The Peoples Daily in China reportedrecently that Asia countries including China areexpected to join Russia, Argentina and South Africainadding to their gold reserves.2. There has been a jump in speculative activity,especially on the Tokyo Commodity Exchange andComex in New York, as investors are betting on ahigher gold price.3. Economies of India and China are booming andMiddle East is awash with petro dollars. Because ofthis there has been a big increase in jewellery buyingfrom these countries. According to the World GoldCouncil in the first nine months of 2005, overalltonnage demand ingold in India was 39% higher thanin corresponding period in 2004, the Jewellerydemand in China rose by 9% during the same periodand inthe Middle East and Turkey, Jewellery demandgrew by 11% while retail investment grew by 28% intonnage terms.4. Major institutional investors are adding gold totheir portfolios in a small way and replacing somedollar denominated short term instruments with gold.Major buying from the strong institution is yet to takeplace. When big funds and institutional moneychases gold as an investment avenue, there may besharp spikes ingold prices.5. In China after years of communist controls, thegovernments has deregulated gold in April 03,allowing gold companies to have IPOs, creating agold exchange and allowing its citizens to buy gold atmarket rates. 1.3bn Chinese citizens are nowpermitted to buy gold at market rates as theyparticipate in their fast growing economy. China byitself could become 40% of the entire gold market.This is an important event in the gold market in the

9


13/30

last five years, and may change the demand patternand very few people have factored this iin the futuregold demand.

Factors Responsible ForShortage Of Supply1.Gold output has matured among traditionalproducers like South Africa, the US, Canada andAustralia. In fact the production is on decline inSouthAfrican gold mines where HIV/AIDS is taking toll onthe work force. Estimates show that South Africa hasproduced less gold in 2005 than anytime in the last80 years.2.The cost of gold production has risen, on accountof high energy prices. According to Numis Securitiesin London, the average production cost for an ounceof gold has risen to USD 362 driven up by energycosts, wage inflation and currency movements.3. The 20 year bear market in gold has forced anumber of marginal gold producers out of businessand significantly curbed exploration and production.If gold was USD 1,000 an ounce, it still takes four toseven years to open amine.

4. In recent years, total retail and industrial demandfor gold has far exceeded the actual gold mined intheworld. Central banks have filled the demand supplygap. About 30% to 50% of the gold reported to be incentral bank vaults was sold and used bymanufacturers. These gold reserves must bereplacedsooner or later with newly mined gold. Howeverforecasts suggest that mine supply may not keeppace with demand due to the lack of explorationwhen gold prices were low and the naturalexhaustion of existing gold mines. A high demandand short supply scenario creates an idealenvironment for gold prices to harden further.

Gold provides safety and security, whichhave always been unique to the status of thisprecious metal. Gold politics, Central bank policies,Currency fluctuations and geopolitical events may beimpossible to predict. A strengthening economy hasthe potential to turn the tide against gold. Even if allthese factors may not work in favour of gold, even ifwe were to consider gold as just a commodity, somebasic supply and demand arguments also are infavour of gold. Thus gold is a long term store of value,highly liquid, internationally recognised asset of last

BullionStrategy: Gold as anAsset Class

resort. It can diversify and stabilise your portfolio andpit against stock market fluctuations.

Gold makes investments inflation proof: Inrecent years gold prices have traded down becauseinflation was low. Historically, gold prices havestrong correlation with inflation. Economic cycles arepermanent facts of life and one of the best reasons toacquire gold today. Even though gold prices fluctuateover the long term, gold has maintained its long termvalue while most commodities and the USD havedeclined in value due to inflation. This is why gold isoften purchased as a hedge against inflation andcurrency fluctuations. Gold prices move upindependently of stocks and bonds often rising whenstock prices fall and vice versa. Thus gold can beused to insure the portfolio of stocks againstunforeseen stock market crash or any other eventslike wars, terror attacks. Thus many experts urgeinvestors to keep a portion of their total assets ingold. Many recommend a holding of 5% to 10% ingold and hard assets. Gold's place in any portfolio isfor safety, security, insurance, protection anddiversification.

10


14/30

Commodities And It's Various Factors

The simplest definition of commodities is that theyareraw materials. Inpractice commodities arebrokendown into several sub-categories Energy, whichincludes crude oil, heating oil and natural gas Grains,which includes corn, soybeans and wheat Industrialswhich consists of copper and cotton Livestock,which includes live cattle and live hogs PreciousMetals, comprised of gold, platinum and silverSofts, including cocoa, coffee, orange juice andsugar. Both supply sideand demand side factors havean impact on the spot prices of individualcommodities, as well as the type of instrumentsavailable to investors wishing to benefit from pricemovements Supply side factors include: the extent towhich production is dependent on the weather; howeasy it is to transport and store the commodity; thelength of the production process, i.e. production leadtimes; and the possibility of increasing supplyelasticity through secondary supply. The uses towhich a given commodity is put will influence theincome elasticity of demand and the price elasticity ofdemand

Supply side factors:It is not difficult to see that production of most

Bullion Strategy: Commodities and its various factors

agricultural commodities is dependent on weatherpatterns at least to some degree. Yet even theproduction of mineral resources is vulnerable tosituations where, for example, extreme floodingmakes it impossible to access mines or leads tounanticipated production slowdowns. In Siberia, thelong winter has an impact on the number of months ayear that alluvial mines can operate. It takes differingamounts of time to produce different commodities,as well as to increase productive capacity. Forinstance, production of some agricultural goods,such as sugar, can be rapidly increased from oneseason to the next, whereas it may take years for acoffee plantation to reach maturity and several yearsto increase productive capacity for most minerals.With respect to mineral resources, factors to takeinto account include the rarity of the resource andhence the effort that must be expended to locatereserves; the time taken to develop those reserves byputting in place the infrastructure required to extractthem; and the commercial viability of extracting thereserves. If it is easy and cost-effective to store acommodity and if acommodity has a long "shelf-life",then this has implications for secondary supply, sinceit then becomes possible to build up stocks that arenot dependent on seasonal variation. Gold, in thiscase, is an extreme example since the availability ofabove ground stocks of gold in the form of bullionbars combined with the existence of awell-developedleasing market means that short run supply rupturesare highly unlikely. In this respect, gold behaves morelike a currency than a commodity, since mostcommodities are susceptible to demand squeezesfrom time to time, which in turn leads tobackwardation in the futures market, i.e. a situationwhere the spot price exceeds the future price.

Demand side factors:(a) Income elasticity of demand - The incomeelasticity of demand describes the extent to whichdemand increases as income rises. Goods are said tobe income-inelastic if they have an income elasticityless than one (most food items). Luxury goods, on theother hand, are regarded as income elastic and havean income elasticity greater than one (demand forthese goods increases more than in proportion toincome increases). Coffee, for instance, is a luxurygood. The income elasticity of demand tells us howindispensable agood (or acommodity) iswith respectto basic economic survival. It also tells us how

11


15/30

demand for particular goods might evolve aseconomies become wealthier, i.e. as incomes, orGOPper capita, rise for acountry as awhole. Further,income can bemeasured both in terms of the generaleconomic wealth of a country as a whole, or splitinto different income groups within a country, ordefined interms of average GOP/capita.(b) Price elasticity of demand - The price elasticity ofdemand tells us how sensitive demand is to a changein price. The easier it is to find a substitute for aparticular commodity, e.g. butter for margarine, themore price elastic demand is likely to be. Where acommodity is virtually unique, demand is more likelyto be price inelastic, i.e. demand is less likely tochange even if the price increases because nosubstitute is easily available. Elasticities are likely tochange over time as patterns of demand evolve.Platinum provides a good example of a commoditywhere new applications revolutionised the structureof demand. "From the mid- 1970s onwards, thetightening of auto emissions regulations stimulated

Bullion Strategy: Commodities and its various factors

major advances in catalyst design". The combinationof technological advances which used platinum,along with other platinum group metals, in catalyticconverters, and environmental regulations thatincreased global demand for these, had ahuge impacton the level and pattern of the platinum price.Research into industrial uses of gold is beginning tobear fruit, although currently industrial uses for goldtypically account for just 11% of overall annualphysical demand

Conclusions:Although commodities can be understood to includean extraordinarily wide range of goods, the universeof investable commodities is restricted to asmall sub-set of these. The range of investment methodsavailable for agiven commodity reflects the nature ofthe commodity itself as well as established patternsof supply and demand.

12


16/30

Economic Cycle And The ReturnsFrom The Commodity

Investors in commodities need to understandthe dynamics of supply and demand and how thesemay impact on price. Given current enthusiasm aboutthe extent to which economic growth in China islikely to continue to underpin a commodity bullmarket, it is extremely important that newcomers tocommodities markets are in a position to discern theextent to which Chinese economic growth can beexpected to boost demand for particularcommodities, and whether such demand can in turnbe expected to lead to sustained increases in theprices of these commodities. This analysis does notset out to provide a comprehensive set of solutions,aiming instead to ask some of the right questions andprovide some useful starting points for theidentification of commodity price drivers and furtheranalysis. When reading the summary information ordoing any analysis for any of the metals, thefollowing key questions should be borne in mind:Which economies are the major consumers of eachmetal and does their economic growth have a direct,contemporaneous impact on demand for each metal?What are the main uses of each metal and how canthis help us form a view on the outlook for demand?To what extent does demand drive price? To whatextent is supply constrained and how important isthis with respect to price movements?

Bullion Strategy: Economic Cycle And The ReturnsFrom The Commodity

SilverDemand for silver is worth around US$ 4.187 billioneach year, with industrial applications accounting forthe largest "market share" at around 40 per cent,followed by jewellery and silverware (32 per cent)and photography (24 per cent). Investment demandfor silver in the form of coins and medals is tiny bycomparison although it has picked up a little since thesecond half of the 1990s. Industrial uses for silverinclude batteries, bearings, brazing and soldering,catalysts, electrical uses, electronics, electroplating,medical applications, mirrors and coatings, solarenergy and water purification. As might beexpected,demand for silver in photography has declined overrecent years due to the expansion of digitalphotography, a trend that is expected to continue.Industrial demand for silver increased by 25 per centfrm 1994 to 2003, equivalent to a compound annualgrowth rate of 2.2 per cent, although this masksconsiderable year-on-year fluctuations inthe fortunesof the precious metal. Electrical and electronics, onthe one hand, and brazing alloys and solders, on theother hand, have accounted for more than 50 percent of industrial uses of silver over the past years, onaverage (41.5 and 11.4 per cent respectively).Likezinc, there appears to be little relationship betweensilver inventories on Comex and the silver price. Onthe supply side, as with the other metals, recycledmetal constitutes a significant share of supply eachyear: around one fifth.

GoldDemand for gold jewellery, industrial applications andworld investment has been worth US$ 38 billion onaverage over the past five years. Of the metalmarkets covered in this analysis, and also includingplatinum and palladium, the gold market is the thirdlargest based on the value of mine production. Thediverse nature of the demand for gold, and the qualityand depth of readily available supply and demanddata, provides an interesting opportunity to use amatrix analysis that could be adapted for a variety ofcommodities. Jewellery is by far the largest categoryof gold demand. Comparison of fabrication demandwith consumption demand provides informationabout the flows between "first-use" and "end-use" ,which is helpful when thinking about the outlook forthe category as a whole. For example, Italy is one of

13


17/30

the top five gold jewellery manufacturing countries,accounting for 10.8% of total identifiable demandfrom all sectors, and in 2003 produced 328.8 tonnesof gold jewellery. However, that same year Italianconsumers purchased only 82.3 tonnes (or aquarter)of that output. The drivers of gold demand vary bysector, i.e. demand for gold inelectronics is driven byfactors unrelated to the factors driving investmentdemand. Similarly, the nature of the gold jewellerymarket is different in what are commonly termed thehigh "caratage" markets than in Western markets.Mine production provides the lion's share of goldsupplied to the market each year 66 per cent butrecycled gold scrap accounts for one fifth, with salesof gold by central banks and similar organisationsmaking up the balance of 14 per cent. Analysts havedifferent views on how gold that is effectively(withdrawn from or) supplied to the market due to the(de)hedging programmes pursued by gold miningcompanies should be incorporated into measures ofsupply and demand. For the purposes of thecalculation here (de)hedging has not been included intotal supply. Like copper, lead and nickel, thereappears to be a fairly direct relationship betweenComex warehouse stocks and gold price movements,thus suggesting that Comex warehouse stocks maybe a useful proxy for short-term supply-demandbalances.

ConclusionAlthough intuitively it makes sense for there to be arelationship between economic growth and demand,the extent to which this impacts on metal prices is notclear, certainly not within the same quarter. There isplenty of scope to deepen such analysis, assumingthat the data required to do so is available. It wouldcertainly be of value to the investment community,whose interest in supply and demand forcommodities is precisely based on how thesedynamics impact on returns. Furthermore, when itcomes to incorporating commodities in assetallocation analysis both strategic and tactical oneneeds to form a view of expected returns. Historicalreturns can provide us with a starting point, but arefar from sufficient when it comes to modellingoptimal allocations for the next period of three to fiveyears or longer. With respect to supply and demand,it is very clear that, when it comes to the metals, it is

Bullion Strategy: Economic Cycle And The ReturnsFrom The Commodity

not sufficient to examine primary supply, i.e. mineproduction, because an increasing proportion ofsupply is derived from recycling. Inventories on theexchanges LME and/or Comex may provide usefulindicators for price trends for a number of metalsbecause they are a ready indicator of the supply anddemand balance. An understanding of growth trendsin end uses of each metal, as well as the potential fornew applications to expand demand, is crucial whenforming a longer-term view. For example, it is notunreasonable to expect that the use of aluminium incar bodies will increase over time. Similarly, givencontinuing economic growth and industrialisation ofChina, it is difficult to dismiss the impact that thedevelopment of Chinese infrastructure will have onthe demand for inputs required for construction, inparticular. The same methodology can be applied tothe analysis of gold supply and demand as for theother metals, and the yellow metal exemplifies theneed to understand the drivers of each segment ofdemand: demand drivers for jewellery differ acrossnations, but these are also very different from thedrivers behind industrial demand for gold, particularlyelectronics, and the drivers behind investmentdemand.

14


18/30

Inflation And Gold

Our inflation measure of choice, the prices ofgold and other precious metals, has been signaling areturn of inflation for some time now; it has taken along time for Wall Street & Sensex to recognize it aswell. If, as we expect, inflation continues, portfoliomanagers will be scrambling to find investmentinstruments with which they can protect theirportfolios from its pernicious effects. There are twoserious candidates that purport to shield portfoliosfrom inflation: "linkers" or inflation indexed bonds(1IBs) referred to in the United States as "Treasuries,Inflation Protected" (TIPs) and commodities,especially precious metals. When we examined theability of inflation indexed bonds (1IBs) to helpimmunize a fixed-income portfolio against inflation,we found that while they are constructed to protectinvestors against fluctuations in official consumerprice indices, they offer little protection againstinflation as measured by commodity prices such asgold. It is argued that if changes in the prices of theprecious metals are a superior measure of inflation,the case for including IIBs ina bond portfolio is weak.Instead, It is proposed that a portfolio that includesgold in some form provides a superior hedge againstinflation. The problem with IIBs that they are issued

Bullion Strategy: Inflation and Gold

by the governments of the United Kingdom, Canada,and United States (among others) to provide an assetthat is not hurt by inflation. The U.S. began issuingTIPs in 1997; British index-linked gilts have beenavailable since 1981; in Canada, they are called RealRate Bonds. Such bonds are advertised to protectinvestors by adjusting the principal amount of thebond and coupons paid in accordance with changesin the official consumer price index of that country.On the surface this seems an effective way toimmunize IIBs from the ravages of inflation, but thereare several caveats:1. Although the par value of an liB is tied to theconsumer price index, its pricing in the openmarket is not. IIBs only hold their "real" value ifheld to maturity. If sold before then, their pricesare subject to the samemarket fluctuations as anyother bond. In fact, the price will be affectedwhenever the market changes its expectations offuture consumer price movements.

2. There is a delay of some months beforeadjustments for inflation aremade.

3. In any case, official consumer price indices aretardy and inaccurate measures of inflation.

4. IIBs protect only that portion of the portfolioinvested in them; they have no ability tocounteract the effect of inflation on other assets.It is difficult to assess the ability of such bonds toact as an inflation hedge

Inflation: finding a better yardstick. :Local-currency price of gold provides an effectiveforecast of the direction of consumer-price inflationthroughout the developed world. Over shorter timeperiods, movements in the price of gold are amultipleof movements in official price indices. And wheninflation was highest inBritain (ten years inwhich theRPIinflation rate averaged 14.4 percent) the price ofgold rose an average of 25.4% per annum during thefour years prior. It shows that the same is true evenmore so, in fact for the U.S. When the CPI increasedmost, at an average rate of 11.1 percent a year, theannualized price change for gold over the four prioryears averaged 36.9 percent. Even the Fed takes aninterest in the gold-price signal. In remarks to the U.S.Congress in 1999, Federal Reserve Chairman AlanGreenspan expressed his long-held opinion thatfalling gold prices are "a reflection of a globalreduction inthe long-term inflation outlook.

15


19/30

Using the bond market to compareindicators of inflation.

Even if an asset could be constructed tomirror the consumer- price index adequately, it mightstill not be immunized against changes in the trueprice level since no accurate measure of this exists.However, we can use the bond market itself ascircumstantial evidence. The question is whethermovements in the price of gold carry informationabout inflation that the official index does not. TheCPI does contain relevant information about inflationto which the bond market reacts, as it has been seenthat bond-market performance is correlated with thechange in the CPI inflation rate over a two-yearperiod. Price changes in the gold market are signifi-cantly more potent interest-rate predictors thanmovements in the CPI. This can beseen by observingthat bond yields increase after the price of gold rises,even if CPI inflation decelerates; whereas bond yieldsdecline after the price of gold falls, even if CPIinflation accelerates. Capital gold held as an asset isfar more sensitive to inflation than indexed debt. Infact, the power of gold to immunize a portfolioagainst loss in an inflationary environment is severaltimes greater than that of IIBs. It is so great, in fact,that it can easily offset the losses that bondsregularly sustain during such periods. Least-squaresanalysis determines that a one percentage-pointacceleration of the CPI inflation rate is associatedwith an 8.8 % pts. increase in the return from gold.This is a much more positive out - come than the2.8% pts. negative return from bonds. The ratiobetween 8.8 and 2.8 is 3.1 to 1. This provides arough estimate of what portfolio mix of gold andbonds would provide immunization against a CPIinflation.

Inflation and equities.Interestingly, persistent inflation does more

damage to stocks than bonds. This becomes evidentwhen we use the price of gold as an indicator of thegeneral price level and compare correlations betweenits year-to-year change and subsequent stock andbond performance. Although bonds are hurt more byinflation than equities in the short term, over time thereverse is true. This means that, contrary to popularopinion, stocks are the opposite of a hedge against

Bullion Strategy: Inflation and Gold

inflation. And since inflation hurts equities as well asbonds, gold serves as aneffective inflation immunizerfor anequity portfolio as well.

Investment implications.T-bond prices are hurt by accelerations inthe

rate of inflation as measured by the consumer priceindex. But the price of gold is several times moresensitive on the upside. Thus including gold ina bondportfolio is an effective way to immunize portfolioreturns against rising inflation. In addition to being asuperior inflation gauge to the CPI itself, gold hassome very attractive properties as an inflationimmunizing asset. While IIBs can only immunize thatpart of the portfolio they represent, and then only interms of par value and not price, gold is an asset thatgoes up with inflation and better still, its priceincreases at several times the inflation rate. Thus goldis an excellent choice for the investor seeking anasset to hedge against inflation. The only immunizingasset we can identify that is superior to gold is abasket of precious metals that includes silver andplatinum inaddition to gold. But there are a couple ofimportant caveats.First, the correlation between gold prices and T- bondprices is very close, but gold leads bonds by ayear. Inorder to take full advantage of the immunizingproperties of gold, the investor must have invested ingold a year before inflation shows up in the CPI data.That's no problem since gold starts moving two yearsahead ofthe CPI.Second, holding gold in a portfolio as inflationdecelerates would bedamaging, because the price ofgold is leveraged on the downside as well as theupside. In the case of a T- bond portfolio, completeprotection implies a portfolio mix of 18 percent goldand 82 percent bonds. The introduction of anypercentage of gold, however, can do nothing buthelp.

16


20/30

Gold Or OilWhich Is Better PredictorOf Inflation

We are now into a second year of extremevolatility in the price of oil. Although the economy sofar is weathering it well, investors are scrambling toadjust their portfolios. But how much does the priceof oil matter? Research indicates that there is notmuch point in formulating broad investment strategybased on what oil is likely to do in the future or evenon what it has done in the recent past. Even if weknew for sure at what level oil prices will stabilize, theeconomic consequences would not be predictable.Farmore significant for the future of inflation and theeconomy as a whole is the price of gold. A largeincrease in energy prices undoubtedly reshufflesresources among sectors within the economy; buthistory refutes the oft-repeated claims that arecession necessarily follows or that inflation mustaccelerate. Three limiting factors apply: a rise in theprice of one commodity (however important) relativeto other commodities is not in itself sufficient to forcea rise in the general cost of living; the number ofepisodes in which the price of oil changedsubstantially in a short period has been too few toserve as abasis for accurate forecasts. This Researchand Analysis here demonstrates the extent to whichthe prices of commodities such as oil and gold serveas leading indicators of unanticipated inflation and

Bullion Strategy: Gold Or Oil Which Is BetterPredicator Of Inflation

interest rates. The evidence presented coversproducer prices, consumer prices and bond yields inthe United States, but other work suggests that therelationships found are not greatly different in othercurrency zones, it will be of substantial interest toinvestors to know that gold is a superior (perhaps thebest available) early warning indicator of inflation.

Gold versus oil as a leading indicator of inflation:There are several ways in which the gold

market provides more accurate information aboutfuture economic and capital market performancethan data from the oil market. For example, thatwhen the price of gold rises, producer- price inflationtends to accelerate in the following year; when theprice of gold falls, it tends to decelerate and when wecombine price data for both gold and oil in a singleleast-squares equation to anticipate movements ineither producer- or consumer-price inflation. Only thegold variable is statistically significant. Thus forpurposes of anticipating inflation one year in thefuture, there is no significant information in the priceof oil that is not already captured by the price of gold.So Why do oil prices serve so poorly as a leadingindicator of inflation? It is true that a rise in the cost ofenergy will tend to drive up the prices of goods in theproduction of which energy is required. But no singlecommodity can drive up the prices of allcommodities. Only the federal government, byallowing the value of the currency to depreciate, cando that. To create a rise in the general price levelrequires more than an increase in the relative price ofa particular group of commodities. Indeed, anenergy-price increase is inherently deflationary. By absorbinga larger slice of the incomes of energy users, it makesmost other commodities less affordable.

Gold versus oil as a leading indicator of the bondmarket:Precisely because it anticipates inflation sowell, goldis also a powerful predictor of nominal interest rates,both long and short. Research and analysis show thatthe time frame that yields the optimum correlation(0.73) between changes in the price of gold andchanges in 10-year T-bond yields is about twelvemonths. The optimum correlation (0.54) between oil-price changes and T-bond yields involves only one-

17


21/30

month time difference. These results reveal tworespects in which the information in the gold price issuperior: gold provides amuch early warning, and thecorrelation with interest rates is significantly tighterregardless of the time frame. But Gold is correlatedwith both oil and bonds, but moves in advance ofboth byabout ayear.

What makes gold different:Because gold moves earlier than official

measures of inflation, it works much better atanticipating monetary policy than "Fed watching."The investment applications of gold are numerous,but not widely recognized. Analysts often try toanticipate where the price of gold is heading;however, knowing where it has already been is farmore fruitful. Despite growing recognition of gold'sforecasting power, investors, schooled to believethat gold is a "barbarous relic" with no modern role toplay or "just another commodity," often resist using itin their investment strategy. Others are concernedthat gold is buffeted bymany bottom-up factors suchas South African politics, Chinese demand, central-bank dumping and so forth, which can distort itsprice. But its forecasting power proves that suchdistortions donot last long.

Why gold is not just another commodity:Gold has served as money over the centuries

precisely because its properties were most conduciveto playing that role. Its primary function throughouthistory has been as a liquid store of wealth, not as anindustrial input. Evenwhen gold is made into jewelry,it is still today a form of currency in large parts of theworld. Unlike other commodities, which are producedfor consumption, gold is produced for accumulation.Virtually all the gold that has ever been mined stillexists today. The purchasing power of gold what itwill buy in terms of other goods and services isnearly constant over long periods of time. Even intheface of large gold discoveries in Latin America in the16th century, in California in the mid-19th centuryand in South Africa and Australia starting in the1890s the world supply of gold increased onlyincrementally each year, and gold held its value.What about its future value? Since gold is adepletable resource, and large discoveries are


becoming increasingly rare, the total stock of goldnow tends to diminish each year. Thus gold'spurchasing power will remain stable, and its role as ameasuring rod will become still more secure.

Why gold forecasts better than other commodities:Gold is different because the reservoir of gold

that is traded in world markets dwarfs any possibleinterruptions inthe annual flow that result from eithersupply or demand. The annual flow of newly minedgold adds only about two percent a year to the goldsupply, far less than for any other commodity,especially oil. This reservoir of gold stabilizes its valuein terms of other goods. Because other commoditiesare major industry inputs, their relative prices changewith the business cycle. Gold is not subject to thesedistortions since it is not a major input to industry.The relative performance of gold and oil as inflationindicators can betraced back to one profound fact: inorder to use gold for its main economic purpose (thepreservation of wealth) it is necessary only to hold it.By contrast, in order to use oil for its main economicpurpose (the production of energy) it is necessary toconsume it literally to destroy it in the process ofconverting it to energy, water, and carbon dioxide.New supplies of oil must be found to replace all the oilthat gets used, whereas the supply of gold isunaffected by its use. Thus the value of oil in terms ofother goods is highly variable; the value of gold interms of other goods is highly stable.

The co-movement of oil and gold prices:The ratio between the prices of oil and gold, over thelong haul, has been something like anatural constant.From the late 1950s to mid-1973 the dollar-price ofoil hardly changed, while that of gold escalated 250percent from $35 under the Bretton Woods system toover $120 an ounce. Then late in 1973 came theSaudi oil embargo and a nearly 300 percent leap inthe price of oil. In 1981 .this upward spiral ended, butthe game of catch-up resumed in reverse DuringReagan's first term, the price of gold fell more than50 percent from an all-time high of $800 in early1980. The price of oil finally broke with a drop ofmore than 50 percent in the first quarter of 1986. Inthe next phase both prices fluctuated, but by 1990the gold-oil price ratio had once again returned to its

18


22/30

long term norm, which we estimate of about 15.5.the dollar-price of oil has revolved around movementsin gold. This behavior accords with the idea that theprice of gold reflects inflationary pressures ingeneral,while that of oil contains information specific to theenergy sector.

Conclusions :Inflation is a monetary phenomenon, by which wemean it is governed by the purchasing power of a


currency interms of "hard money" benchmarks. Howto tell whether government actions are combating oraccommodating inflation? Watch gold, not oil. Theprice of gold is a reliable barometer of the value of thedollar; the price of oil is not. The effect on officialinflation statistics and bonds alike is reliably indicatedby how far policy actions have allowed the price ofgold to rise.

19


23/30

Why Gold Is Different From OtherAssets?

Sudden unanticipated increase in the demandfor a given commodity that is not met by animmediate increase in supply should, all else beingequal, drive the price of the commodity upwards.However, it is generally beleived that, in the case ofgold, buffer stocks can be supplied with perfectelasticity. If this argument holds true, no suchupward price pressure will be observed in the goldmarket in the presence of a positive demand shock.Gold Fields Mineral Services Ltd estimate the above-ground stocks of gold to have been some 145,200tonnes at the end of 2001, a figure that dwarfsannual new mined supply of around 2,600 tonnes.Much of this is held in a form that can readily comeback to the market under the right conditions. This isobviously true for investment forms of gold but it isalso true for much jewellery in Asia and the MiddleEast.

The existence of a sophisticated liquidmarket in gold leasing has, over the past 15 years,provided a mechanism for gold held by central banksand other major institutions to come back to themarket. Although the demand for gold as an industrialinput or as a final product (jewelry) differs across

Bullion Strategy: Why Gold Is DifferentFrom Other Assets?

regions, However the argument is that the core driverof the real price of gold is stock equilibrium ratherthan flow equilibrium. This is not to say thatexogenous shifts in flow demand will have noinfluence at all on the price of gold, but rather that thelarge supply of inventory is likely to dampen anyresultant spikes in price. The extent of thisdampening effect depends on the gestation lagwithin which liquid inventories can be converted inindustrial inputs. In the gold industry such time lagsaretypically very short.

Gold has three crucial attributes that,combined, set it apart from other commodities:firstly, assayed gold is homogeneous; secondly, goldis indestructible and fungible; and thirdly, theinventory of aboveground stocks is astronomicallylarge relative to changes in flow demand. Oneconsequence of these attributes is a dramaticreduction in gestation lags, given low search costsand the well-developed leasing market. One wouldexpect that the time required to convert bullion intoproducer inventory is short, relative to othercommodities which may be less liquid and lesshomogenous than gold and may require longer timescales to extract and be converted into usableproducer inventory, making them more vulnerable tocyclical price volatility. Of course, because of thevariability of demand, the price responsiveness ofeach commodity will depend in part on precautionaryinventory holdings.

Finally, there is low to negative correlationbetween returns on gold and those on stock markets,whereas it is well known that stock and bond marketreturns are highly correlated with GOP. This isbecause, generally speaking, GOP is a leadingindicator of productivity: during a boom, dividendscan be expected to rise. On the other hand, theincreased demand for credit, counter-cyclicalmonetary policy and higher expected inflation thatcharacterize booms typically depress bond prices.

The fundamental differences between goldand other financial assets and commodities give riseto the following "hard line" hypothesis: the impact ofcyclical demand using as proxies GOP, inflation,nominal and real interest rates, and the term structureof interest rates on returns on gold, is negligible, incontrast to the impact of cyclical demand on othercommodities and financial assets.

20


24/30

Using the gold price and US macroeconomicand financial market quarterly data from January1975 to December 2001, the following conclusionsmay be drawn:(1 )There is no statistically significant correlation

between returns on gold and changes inmacroeconomic variables, such as GOP, inflationand interest rates; whereas returns on otherfinancial assets, such as the Dow Jones IndustrialAverage, Standard & Poor's 500 index and 10-year government bonds, are highly correlatedwith changes in macroeconomic variables.

(2) Macroeconomic variables have a much strongerimpact on other commodities (such as aluminium,oil and zinc) than they do on gold.

(3) Returns on gold are less correlated with equity andbond indices than are returns on othercommodities.

Assets that are not correlated withmainstream financial assets are valuable when itcomes to managing portfolio risk. This researchestablishes a theoretical underpinning for theabsence of a relationship that has been demonstratedempirically for a number of years; namely, thatbetween returns on gold and those on other financialassets.

The purpose of this study is to explore certainattributes of gold, which distinguish it from othercommodities. More specifically, we are concernedwith testing a theory as to why gold is so littlecorrelated with financial assets. Generally, the flowdemand of any commodity is driven primarily byexogenous variables such as GOP or absorption. Tothe extent that gold behaves like other commodities,one would expect that a sudden unanticipated rise inthe demand for gold which cannot be matched by animmediate increase in supply should, all things beingequal, drive the price of gold up. However, it is arguedhere that the supply of gold is perfectly elastic, giventhe existence of large, homogeneous and liquidabove-ground stocks.

The above argument can be stated formallyas a set of inter-related hypotheses as follows:


(1) Changes in real GOP, short term interest rates andthe money supply are not correlated with the real rateof return of gold.(2) Changes in real GOP, short term interest rates andthe money supply are correlated with real returns onequities and bonds.(3)Real rates of return on durable commodities otherthan gold such as oil, zinc, lead, silver and aluminiumare correlated with real changes in GOP, short terminterest rates and the money supply.(4) Given that hypotheses 1, 2 and 3 hold, one mayhypothesize further that:(a) Returns on gold are not correlated with those on

equities and bonds. This is tantamount tosuggesting that whilst core macroeconomicvariables are the critical determinants of financialindex performance, they have no impact on thereal price of gold.

(b) Returns on other commodities are correlated withreturns on equities and bonds.

(C) Whilst returns on gold may be correlated withreturns on other commodities, this correlationtends to be small, and is a function of the extent towhich the other commodities share the crucialattributes of gold that set it at the extreme end ofthe continum ranging from highly liquid to veryilliquid supply.

Conclusions :The above details tells us that whether or not the goldprice is "insulated" from the business cycle, incontrast to other financial assets and commodities.The "insulation" hypothesis hinges on the fact thatthe supply and potential supply of inventory used inmanufacturing is huge in contrast to the flow demandof gold as an input. As aggregate demand risesthrough the cycle, the increased demand is easily metthrough the incipient increase in supply withoutpressure on the gold price. Commodities whichexhibit all or most of the characteristics of gold suchas homogeneity, indestructibility, liquidity,identifiability and short inventory gestation lagswould also tend to exhibit price behaviour which isinsulated in part from the business cycle. Byexamining simple correlations and using dynamicVAR analysis we cannot reject our four corehypotheses:

21


25/30

(A) GOP and other core macro economic variables areuncorrelated with the real rate of return of gold.(b)Core macro economic variables are correlated with

the S&P index, the Dow Jones Industrial Index, amoney market index and a bond index (allvariables are defined as real rates of return).

(c)Real rates of return of other commodities otherthan gold such as oil, zinc, lead, silver, aluminium,copper and the CRB index are correlated withmacro-economic variables.


(d)Gold and the financial indices are uncorrelated(this is tantamount to suggesting that the abovemacro-economic variables are the criticaldeterminants of financial index performance).

(e)Other commodities and financial indices arecorrelated since the core risk factors are driven bythe business cycle.

22


26/30

Value Of GoldAn object or product can be said to have

subjective value for example, the pleasure obtainedfrom a piece of gold jewellery or objective value, if itis widely accepted in exchange for other goods andservices. Gold is unusual inthat it has long possessedvalue in both these senses. This analysisconcentrates on gold's objective store of value. Ifgold is to function successfully as a store of value itmust either maintain its rate of exchange with othergoods and services or, at least, beexpected to returnto an historical rate of exchange. It is said that anounce of gold bought 350 loaves of bread in the timeof Nebuchadnezzar, king of Babylon, who died in 562Be. The same ounce of gold still buys approximately350 loaves of bread today. Across 2,500 years goldhas in other words retained its purchasing power,relative to bread at least, and has had a real rate ofreturn of zero. "The lesson is that, although the goldprice may fluctuate ...gold has consistently revertedto its historic purchasing power parity against othercommodities and intermediate products. Over time,gold has proved to be an effective preserver ofwealth. In periods of economic and social instability,when the value of other assets has been all but wipedout, gold has beenasafe haven. "

Bullion Strategy: Value of Gold

During the 100 years between 1896 and1996, in terms of cumulative wealth, gold has under-performed stocks and government bonds in the USand Britain. In France, which has tended toexperience greater inflation than Britain and the US,gold has performed comparatively better againstother asset classes, whose returns have sufferedthrough inflation. In Germany and Japan during thistime-span severe economic and monetary criseswiped out much of the cumulative wealth frominvestments in stocks or government bonds. Holdinggold was a more effective means of wealthpreservation than holding other assets between1940 and 1949, in France, Germany and Japan,countries that experienced massive economicupheaval and high inflation. During Germany'seconomic turmoil of 1918-24, which virtually wipedout the values of bonds and stocks, gold maintainedits purchasing power. Gold has not necessarily heldits value in terms of purchasing power in times ofwar. This is partly because at such times the prices ofother commodities, more immediately useful for thewar effort, have tended to rise faster. However,gold's liquidity, acceptability and portability arequalities that have been particularly important intimes of crises such as occupation by aforeign poweror collapse in a monetary system. At such times,these qualities may well be more important thangold's rate of exchange with paper money. Giventhis, and gold's role as awealth preserver in some ofthe darkest periods of the twentieth century, gold hasproved to be a haven on numerous occasions and indifferent places. Ultimately, the historical lesson fromthe study of the US, Britain, France, Germany andJapan is that, although the gold price may fluctuate,over the very long run gold has consistently revertedto its historic purchasing power parity against othercommodities and intermediate products. Over time,gold has proved to be an effective preserver ofwealth. In periods of economic and social instability,when the value of other assets has been all but wipedout, gold has also proved to bea safe haven.

The 1970s rise in the gold price whichpushed gold's price above its long-run rate ofexchange with other commodities and intermediateproducts could be seen as mainly a reaction to theprolonged period during which gold had been held at afixed price. Equally, gold's subsequent fall in pricecould be seen as, retrospectively, a comprehensibleand perhaps necessary return to the historic mean.

23


27/30

Yet even if convertibility marked a sea-change in thebehaviour of gold, whether the gold price will revertto an historic mean must to some extent depend uponits demand and supply fundamentals. Since 1971the demand for gold has consisted of demand for it asmoney; increasingly as a commodity, in other wordsgold with a physical use (by the jewellery orelectronics sectors for instance); and as a store ofvalue (by those who are seeking a speculative asset,for example). Gold supply derives from newly-minedproduction, scrap, disinvestment and official sectorsales by central banks that accumulated hugereserves as a result of convertibility. By 1997, thecombined annual sources of supply of gold accountedfor approximately 3 per cent of the estimated aboveground stocks of gold. Although the bulk of theannual supply comes from mine production, thisproportion has been falling (as has the proportionrecycled from scrap) with acorresponding increase inthe proportion from central banks.With respect to thetotal stock of gold above ground, around a quarter isofficial holdings (mostly central banks): total worldstocks at the end of 1997 were approximately134,800 tonnes, with central banks holding nearly31,900 tonnes. As central banks hold such a highproportion of above-ground stocks their actions cangreatly affect the market. Moreover, sales fromcentral banks defy analysis in terms of going marketprice; they tend to be price-affective rather thanprice-reactive. Future action by the central banks isimpossible to predict but the trend in the last decadehas been for increased sales: such sales accountedfor less than 1 per cent of the total supply in 1987,but nearly 10 per cent in 1997. Demand factors havealso changed. Gold still has a monetary role in manyeconomies such as India and China, but - sinceBretton Woods this has largely ceased to bethe caseamong more industrialised nations such as the US,France and Britain. In global terms gold demand isnow much more reliant on its role as a commoditythan it was pre-1971 . Several factors have impingedupon this demand since 1971, includingderegulation; the strong growth in demand for goldjewellery and other industrial uses includingelectronics; and (to a lesser extent) gold's role as adiversifier gold's counter-cyclical movement againststocks and bonds could be used to diversify multi-asset portfolios. Another important factor is thestrong speculative component to demand. Gold has ahigh elasticity of expectations, as the ratio ofexpected price increases to present price increases ishigh. Put simply, the speculative component feeds


off itself. Changes in the price of gold tend to havemultiplier effects in the direction of change, whichaccounts for at least part of the volatility of the goldprice since 1971. Given that in the US the averageannual gold price in real terms has been higher duringthe last 25 years than the previous 200, thederegulation of gold after 1971 (a direct result ofmoving away from convertibility) would seem toimply that increased average annual demand (from allsources, including speculative) outstripped supply.

Ultimately the lesson from the experiences ofthe US, Britain, France, Germany and Japan is that,although the gold price may fluctuate, over the verylong run gold has consistently reverted to its historicpurchasing power parity against other commoditiesand intermediate products. Historically, gold hasproved to be an effective preserver of wealth. It hasalso proved to be a safe haven in times of economicand social instability. In a period of a long bull run inequities, with low inflation and relative stability inforeign exchange markets, it is tempting for investorsto expect continual high rates of return oninvestments. It sometimes takes a period of fallingstock prices and market turmoil to focus the mind onthe fact that it may be important to invest part ofone's portfolio in an asset that will, at least, hold itsvalue. History suggests, and the global economiccrises and uncertainties experienced in the pastcouple of years add force to the suggestion, that overthe long run periods of economic turbulence areinescapable. While participants inmarkets may knowthat such periods will occur they will seldom, if ever,be able to predict with much precision when they willoccur. Even in a major European economy such asGermany, where it is tempting to believe that relativestability is the norm, in living memory there have beenperiods of huge economic upheaval.

The increase in gold's volatility since 1968has led to claims it can offer investors significantbenefits by diversifying risk within a multi-assetportfolio. Looking at the historical correlationbetween the movement in the real gold price indexand changes in the cumulative wealth (total return)indices of other assets, an interesting pictureemerges. Since 1968 the annual movement in thegold index has been negatively correlated withchanges in the cumulative wealth indices of both UST-bills and longer-term government bonds. Returnson gold have been slightly negatively correlated withreturns on stocks. This implies that gold could have

24


28/30

served as a risk diversifier in a multi-asset portfolio.For example, one could have used gold to hedgeagainst a stock market correction. From 1968 to1996 buying 100 per cent equity in a random year tosell in a subsequent year would give, on average, anannual return of just over 6 per cent with a standarddeviation of approximately 8 per cent. Starting at thesame point (a 100 per cent holding of equity) andincreasing the holding of long-term governmentbonds, there is an initial decrease in both return andrisk, but after moving to a portfolio consisting ofapproximately 55 per cent equity and 45 per centbonds, standard deviation (risk) increases as averageannual return decreases. With gold the results areinteresting. Moving from aportfolio consisting of 100per cent equity to one consisting of 75 per centequity and 25 per cent gold increases returns whilesignificantly decreasing risk. This is a result of thenegative correlation between the annualised returnfrom investing in gold and the annualised return frominvesting in the cumulative return Dow Jones equityindex

Gold has not always held its value in terms ofpurchasing power in periods of instability such as theNapoleonic Wars, the American Civil War, theFranco-Prussian War, World War I, World War II orthe Gulf War. Part of the reason for this, at least, isthat in times of war the prices of other commodities,more directly needed for the war effort, tend to risefaster. However, during periods of occupation by aforeign power or the collapse of a monetary system,gold's liquidity, acceptability and portability havebeen particularly important qualities and may well bemore pertinent than gold's rate of exchange with


paper money. In periods of economic dislocation andhigh inflation gold has consistently proved a betterwealth preserver than other assets.

At the turn of the century nobody could haveanticipated two world wars and a rash of smallerarmed conflicts, nor that economies such as theGerman, French or Japanese would experience acollapse of their financial institutions and bouts ofmassive inflation. As we approach the next century,the future is equally unpredictable. We may beawareof future events that could potentially trigger adestabilisation (for example, the introduction of theeuro currency in the EU, the Millennium" bug", or theJapanese banking crisis) but we cannot knowwhether such a destabilisation will happen nor howserious it might be. It is against this background ofperennial economic uncertainty that gold's continuedfunction as astore of value needs to be recognised.

Purchase Power Parity:A theory stating that over the long term the exchangerate between two currencies adjust according tocurrencies relative purchasing power. Inother wordsthe exchange rate adjust so that an identical good intwo countries has the same price when expressed inthe same currency. For example a chocolate bar thatsells for CAD $ 1.50 in a canadian city should costUSD $ 1.00 in a U.S. City when the exchange ratebetween Canada and the U.S. Is 1.50 CAD/USD(Both chocolate bars cost USD$ 1.00)

25


29/30

BullionStrategy: Sources

Sources

owww.mcxindia.como Financial Planning Journal (Issue 6 / March 2006).oWorld Gold CounciloGlobal Insighto KITCOo London Metal Exchangeo Johnson Matheyo Katharine Pulvermacher0CRUoWorld Bureau OfMetals Yearbook 2004oThe Silver Institute/GFMSo H.C. Wainwright & CO.o International Financial StatisticsoGold Field Mineral Services Ltd.owww.thefreedictionary.com

26
http://www.mcxindia.com/http://www.thefreedictionary.com/http://www.thefreedictionary.com/http://www.mcxindia.com/


30/30

c S J G 6~FJPPFAS

Parag Parikh Financial Advisory Services Limited130j132,Great Western Building,lst Floor, S. B.Marg, Near Lion G

bullion strategy

Documents