The price of gold has been rising and might touch Rs 30,000 per ten grams very soon(it is currently around Rs 29,300 per 10 grams). If you had invested Rs 1 lakh in gold five years back, it would currently be worth around Rs 3.1lakh. In comparison Rs 1 lakh invested in the stocks that constitute the BSE Sensex would now be worth Rs 1.22 lakh.
So clearly gold has done much better than Indian stocks have. But will it continue to give the kind of returns that it has in the past? Before I try and answer that question, let’s get into a little bit of history and try and understand why people buy gold.
Queen Elizabeth I who ruled England in the sixteenth century used to have a financial advisor by the name of Sir Thomas Gresham. Gresham had been appointed to clear up the financial mess created by the Queen’s father Henry VIII and her brother Edward VI, who had ruled before her.
Between them they had completely destroyed the pound by debasing it and ensuring that there was very little silver left in it. Kings and governments throughout history have had a habit of debasing coins and other forms of money. Nero, King of Rome, and who watched it burning, was one of the first Kings to debase coin.
Debasement was a practice where the ruler or the government of the day decided to lower the metal content of the coin while keeping its value unchanged. Let us try and understand this through the example of a coin which has a face value of 100 cents (or any other unit for that matter). The face value of a coin is referred to as its tale. This coin is made up of a metal (gold or silver) and the metal content of the coin is worth 100 cents as well. The metal content in a coin is referred to as specie.
So in this example the tale of the coin is equal to its specie, which is the ideal situation. Now the ruler decides to debase the coin by 20%. So he reduces the metal content or the specie value of the coin by 20% to 80 cents. But at the same time he maintains the face value of the coin at 100 cents. And thus debases the coin.
In most situations the rulers used to pocket the metal (gold or silver) they had saved by debasing the coin. The situation in Britain at the start of Elizabeth’s rule was similar and the market that was full of debased coins.
She wanted to correct the situation and decided to launch new silver coins where the tale of the coin was equal to its specie i.e. the face value of the coin was equal to the amount of metal in it.
But her financial advisor Gresham thought that there would be a major problem in doing that. He felt that the bad money would drive out the good. This essentially meant that the citizens of the country would hold onto the full metal new coins and try and carry out their transactions through the existing debased coins.
They would melt the newer coins for the greater amount of silver in them and sell them for their precious metal content. Hence bad money would drive out the good. This phenomenon came to be known as the Gresham’s law. Gresham decided to solve problem by exchanging all the old coins for new coins. This would ensure that there would be no old coins in the market and people would move onto using the new coins as money.
Even though Gresham’s name came to be attached to this phenomenon, this had been happening for thousands of years. “,“Under the Greeks and Romans, when gold coins were debased, few people were dumb enough to want to exchange their old coins that had high gold content for newer ones that had low gold content, so older good coins disappeared as people hid them,” writes hedge fund manager John Mauldin.
In fact it is even being observed today, though in a different form. Central banks and governments around the world have been printing money in the hope of tiding over the financial crisis and reviving economic growth in their respective countries.
When the governments print money there is much more money in the financial system than before, and hence the money gets debased. To protect themselves against this debasement people buy gold, something that cannot be created out of thin air and thus is expected to hold value.
So as governments have been printing money, people have been buying gold and the price of gold has been going up. Till early 1930s, paper money around the world used to be backed by gold or silver. This meant that citizens at any point of time could go to the central bank of the governments and its various mints and exchange their paper money for gold or silver.
Hence whenever people saw that the government was resorting to money printing, they could get their money converted into gold or silver, and thus ensure it did not lose its value. Now the paper money is not backed by anything except a fiat from the government which deems it to be money.
Given this, now whenever people see more and more of paper money, the smarter ones simply go out there and buy that gold. Hence, as was the case earlier, bad money (that is, paper money), drives out good money (that is, gold) away from the market.
But that’s just one part of the story. The governments around the world are likely to continue printing more money, in the hope that people spend this money and this revives economic growth. This in turn would mean that the price of gold is likely to go up in dollar terms. It is important to remember that gold is bought and sold worldwide in dollar terms and not in terms of Indian rupees. Hence whether Indians will continue to benefit from the price of gold continuing to go up will depend on a few other factors.
Let us examine four possible scenarios:
1) The price of gold goes up in dollar terms and the rupee continues to depreciate against the dollar: This is what has happened over the last one year. In dollar terms gold has given a return of 6.1% over the last one year. But in rupee terms the return is almost four and a half times more at 27.3%. Why is this the case? A year back one dollar was worth Rs 44. Now it’s worth almost Rs 54. So the gold price has increased in dollar terms but because of the depreciation of the rupee, the returns of gold in rupee terms are a lot higher. If gold quotes at $1600 per ounce (around 31.1grams), and one dollar is worth Rs 44, then the price of gold in rupee terms is Rs 70,400(1600 x 44) per ounce. If one dollar is worth Rs 54, the price of gold increases to Rs 86,400 per ounce. So the depreciation of the rupee against the dollar can spruce up returns for the Indian gold investor. Even if gold prices remain flat, and the Indian rupee keeps depreciating against the dollar, there is money to be made in gold. But the ideal situation for an Indian gold investor is that the price of gold goes up in dollars and at the same time the rupee depreciates against the dollar.
2) The price of gold in dollar terms falls and the rupee depreciates against the dollar, so as to knock off the fall in price in dollar terms: This is a phenomenon that has been observed over the last six months. The price of gold in dollar terms had gone down by around 7.4%, whereas in rupee terms the return on gold has been around 1%. This is because six months back one dollar was worth around Rs 51, now it’s worth Rs 54. So even though the price of gold has fallen in dollar terms, a depreciating rupee has more than made up for it.
3) The price of gold in dollar terms falls and the rupee appreciates against the dollar: This is a scenario that the Indian gold investor does not want. An appreciating rupee will further accentuate the negative returns of gold. This is a scenario that is highly unlikely. The chances of gold price falling majorly remain low as there is no end in sight to the financial crisis. Also with the government of India being in the mess it is, the chances of rupee appreciating also remain very low.
So the moral of the story is that even if the price of gold goes up in dollar terms, for Indian gold investors to continue to make money, the rupee has to either depreciate against the dollar or to at least remain flat. The rupee is likely to continue to lose value against the dollar and thus there are still more gains to be made on gold. But these gains will be rather limited till gold does not rally majorly against the dollar, which it hasn’t for the last one year.
The moral of the story is that stay invested in gold. But don’t bet your life on it.
(The article originally appeared on http://www.firstpost.com/investing/gold-is-about-to-touch-rs-30000-what-to-do-now-299622.html on May 7,2012. Vivek Kaul is a writer. He can be reached at [email protected])