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GMOEmErging ThoughTs

April 2013

Present and Emerging Risks to the Gold Trade

Amit Bhartia and Matt Seto

The notion of gold as a hedge against systemic risks is awed. We believe that the concept of golds role as aninsurance policy needs to be narrowed signicantly.Last year1 we argued that relying on conventional wisdom to analyze gold price movements is naive. Conventional

wisdom would lead us to believe that gold price movements are driven solely by the actions of developed markets

central banks. We believe this view is misinformed and that the available data does not support it.

In that paper, we argued instead that the key driver of the signicant rise in gold prices since 2000 has been the emerging

markets consumer. Between 2000 and 2010, consumers in emerging markets accounted for 79% of total demand.

Conversely, ETF purchases accounted for only 7.5% of demand and central banks in aggregate were net sellers.

This expanded framework demonstrates that gold is also positively exposed to pro-cyclical factors in the emerging

markets. Moreover, given the cyclical challenges golds key consumers may be facing, the value of gold as insurance

should be questioned.

Over the past 13 years, the impact of emerging markets on gold prices was unequivocally positive: emerging markets

drove gold prices higher. However, this has not always been the case through history and, we believe, will not always

be the case going forward. Emerging markets can be both a positive and a negative driver.

The impact of the Asian nancial crisis is instructive. As the economies in the region fell into recession, the purchasingpower of consumers in Southeast Asia declined commensurately. Thailand, Indonesia, and Korea all became net

sellers of gold, albeit briey (see Exhibit 1). In line with the drop in demand and the drop in the regional stock

markets, gold prices fell 25% (see Exhibit 2).

1 Amit Bhartia and Matt Seto, Emerging Consumers Drive Gold Prices: Who Knew? January 2012.

Source: Bloomberg and World Gold Council

Exhibit 1Gold Demand During Asia Financial Crisis


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2GMO Present and Emerging Risks to the Gold Trade April 201

While we do not necessarily believe that another Asia nancial crisis is looming, the two biggest sources of gold

demand the economies of India and China are coming under increasing pressure. This pressure may have already

been dampening gold prices and may continue to do so going forward. According to the World Gold Council,

consumer demand in India and China accounted for 37% of total gold demand in 2012.

India

Since 2009, Indian gold demand has been somewhat unusual, with a burst of demand followed by a rapid deceleration

(see Exhibit 3). The slowdown in Indias economic growth is at the crux of this change in gold demand.

Exhibit 2Gold Prices vs. Regional Stocks Market Indices (in US$)

Source: Bloomberg and World Gold Council

Exhibit 3Indian Consumer Gold Demand

Source: GFMS Ltd. (a subsidiary of Thomson Reuters)


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Indias GDP growth has come down from the 8% to 10% rates of growth achieved between 2004 and 2010 to 4% to

5% growth over the more recent past, which is at a decade low. Its not clear the infrastructure was in place to sustain

growth at 8% to 10%. We had always believed that a slowdown was likely. Our expectations became reality when

much-needed reforms were not passed by the government.

In line with the economic slowdown post 2008-09, the Indian government went on a spending spree to revive domestic

consumption. The budget decit increased from an average of 3.5% from FY05 to FY08 to an average of 5.7% from

FY09 to FY12 (see Exhibit 4). Higher spending by the government led to higher ination, which saw a rise from 2.3%

in 2009 to over 9% in 2011. The rupee has continuously depreciated since 2008, having fallen by around 40% since

then. Economic risks combined with high ination made Indian consumers worry about the decline in purchasing

power, causing them to buy gold. The buying of gold by Indian consumers and high imported ination due to rupee

depreciation led to a steep rise in the current account decit, which in the quarter ending 2012 stood at 6.7% of GDP.

Then, starting in late 2011, the continuation of these economic trends pushed gold demand in the other direction. A

slowdown in economic growth limited the wealth gains of Indian consumers. Moreover, the depreciated rupee made

gold that much less affordable in local currency terms.

This downward trend has been exacerbated by the governments intervention in the gold market. Stung by concerns

of the high current account decit, the government is in effect shooting the messenger by targeting the gold market, as

opposed to attacking the heart of the problem. Gold imports account for 3% of GDP per year. Without gold imports,

the current account decit would be 2% instead of an average of 5%. In its awed response, the government raised

custom duties on gold imports to 6% from 4% (according to Reuters). Effective February 15, 2013, parliament

amended the PML Act, which heightened compliance standards for gold dealers. Even more worrisome, the nance

minister has publicly discussed banning gold imports for one year. We do not believe that such a drastic step will be

taken, but we also do not rule it out.

Exhibit 4Budget Defcit and Gold Imports

Source: Reserve Bank of Inda, CEIC


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China

Similar to India, consumer gold demand in China cooled considerably in 2012, falling marginally on an absolute

basis. This was in stark contrast to 2011 and 2010 when gold demand grew 22% and 32%, respectively (see Exhibit 5).

We believe that the strong demand in 2010 and 2011 was not so much the beginning of a higher sustained rate of

growth, but a series of one-off events. The 2009 stimulus that led to the booming physical economy brought enormous

grey income demand in 2011. But, the reshufing of both central and local government ofcials introduced greater

political uncertainty. Similar to the previous political cycle, this heightened gold demand.

More troublesome, as Edward Chancellor and Mike Monnelly point out, Chinas credit system and economy are

vulnerable. From their recent GMO white paper2 on China:

China today seems to be in a similar predicament to several of the developed economies prior to 2008. Too much

credit has been created too quickly. Too much money has been poured into investments that are unlikely to generate

sufcient cash ows to pay off the debt. Last year, for instance, new credit extended to the non-nancial sector

amounted to RMB 15.5 trillion. Thats equivalent to 33% of 2011 GDP The latest surge of credit follows the great

tsunami of 2009, when Chinas non-nancial credit expanded by the equivalent of 45% of the previous years GDP.

Since that date, Chinas economy has become a credit junkie, requiring increasing amounts of debt to generate the

same unit of growth. Between 2007 and 2012, the ratio of credit to GDP climbed to more than 190%, an increase of

60 percentage points. Chinas recent expansion of credit relative to GDP is considerably larger than the credit boomsexperienced by either Japan in the late 1980s or the United States in the years before the Lehman bust.

Chinas gold demand is very sensitive to changes in economic conditions. In 2012, China retail sales alone accounted

for 17.6% of global gold demand. Of this, roughly two-thirds came in the form of jewelry. If China gold demand

were to slow, the impact on gold prices would likely be signicant.

2 Edward Chancellor and Mike Monnelly, Feeding the Dragon: Why Chinas Credit System Looks Vulnerable, January 2013.

Exhibit 5YoY % Change in Quarterly Gold Demand

Source: GFMS Ltd. (a subsidiary of Thomson Reuters)


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Disclaimer: The views expressed herein are those of Amit Bhartia and Matt Setoand are subject to change at any time based on market and other conditions.

This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are

for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

Copyright 2013 by GMO LLC. All rights reserved.

Mr. Bhartia is a portfolio manager for GMOs Emerging Markets Equity team and oversees fundamental research. Prior to joining GMO in 1995, he worked

as an investment advisor in India. Mr. Bhartia earned a Bachelor of Engineering at the University of Bombay and an MBA at the Institute for Technology and

Management in Bombay. He is a CFA charterholder. Mr. Seto is engaged in fundamental research for GMOs Emerging Markets Equity team. Prior to joining

GMO in 2008, he was a vice-president in the global markets group at HSBC. Mr. Seto earned his BA in economics from the University of Michigan and his

MBA from Columbia University.

Conclusion

The concept of gold as a general insurance policy against systemic risks is dangerous, especially today. Gold prices are

driven both by global monetary policy and emerging markets consumers. Emerging markets have been a signicant

positive force on gold prices for such a long time that its easy to forget that their impact on gold can very well go in

both directions. Gold prices not only have extensive exposure to China and India, but their exposure to these countries

is pro-cyclical by nature. Given both the cyclical and structural challenges the Chinese and Indian economies are

facing, we believe the risks to gold prices today are particularly high.

The authors would like to thank Alvaro Pascual and Uday Tharar for their assistance in the preparation of this paper.

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