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Is investing in gold risky?

By Chand Mehra
March 16, 2009 10:54 IST
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Investing during this period of global financial turmoil is a challenge. Stock markets around the world are at record lows. Commodities (except for gold) have corrected sharply.

Oil is a prime example, having corrected to $45 per barrel from its peak of $147 a barrel in 2008. Real estate values continue to plummet. The global financial sector, i.e. banking and insurance, is in turmoil. And, the global economy is expected to contract sharply during 2009.

An asset that some analysts are trying to push to investors during these troubled times is gold.  Gold is considered a traditional safe haven asset. Some hedge fund managers believe that because of its safe haven status, gold is a good bet during these troubled times.

The sharp rally in gold prices in February 2009 to a high of $1,007 an ounce is believed to be attributable to buying by speculative hedge funds. Gold price has since corrected by approximately $77 and is currently trading around $930 per ounce. 

A number of advisories are projecting that gold will climb higher. UBS, a prominent gold dealer, recently advised investors to increase their investment allocation to gold as it has an upside potential of $2,500 an ounce. (The UBS advisory mentions the downside risk at $500 an ounce). 

Mining CEO's are doing their bit to highlight gold's safe haven status so as to attract investors. Die hard gold enthusiasts, also known as gold bugs, believe that this is just the start of the gold rally.

The contra view

Contrarians believe that gold is overpriced and it is only a matter of time before it corrects sharply, similar to the correction experienced by other commodities.  The information that is trickling in from different parts of the world on the demand destruction that is occurring on account of the high gold prices suggests that gold is in for challenging times and will be volatile. If you are thinking of investing in gold at current prices, you would be wise to consider the following:

  • Gold's status as a traditional safe haven asset was a result of the world's monetary system being based on gold.

  • The world's monetary system is no longer based on gold.

  • 75 per cent of the world's demand for gold is jewellery based. The liquidity of gold is dependent on the demand for jewellery.

  • The demand for jewellery has a bearing on gold prices and vice-versa.

    Jewellery demand down

    The global picture for jewellery demand is gloomy.  Jewellery demand in the United States, Europe and Japan is badly affected by the global slowdown. The Italian jewellery manufacturing industry is in the doldrums. Gold imports by Turkey, a major jewellery manufacturing centre, were reported to be zero during the months of January and February 2009. Gold sales in Dubai were reported to have fallen by 60 per cent year-on-year (y-o-y) in January 2009. Gold sales in Abu Dhabi were reported to have fallen 70 per cent y-o-y during the months of January and February 2009. Reports of jewellery demand in other countries including Russia, Saudi Arabia, etc are equally depressing.

    Dips in India too

    India is the world's largest consumer of gold accounting for 25-30 per cent of the total gold consumption. India's demand for gold is met through imports and recent gold import figures highlight the demand destruction that has taken place-- imports of gold are reported to have fallen by 83 per cent in December 2008 and by 91 per cent in January 2009. India is reported to have imported zero gold in February 2009; imports so far during March 2009 is also zero.

    The fall in gold imports is not the only indicator of demand destruction in India.  Jewellery retailers across the nation are reporting that sales have been impacted drastically. As per reports, a prominent jewellery mall in Gujarat has reported that whereas the average customer flow was 80 to 90 a day, they are getting not more than 8 to 9 customers a day. The high price of gold has led to unprecedented demand destruction in India. A factor that has worked as a force multiplier in increasing domestic gold prices is the 33 per cent depreciation of the rupee (against the dollar) from 39 a year ago to about 52 now.

    Jewellers in India offer their customers a buy back option at the prevailing rate of gold. Customers are using the opportunity of high gold prices to book profits. The demand destruction in India has been unprecedented. Many jewellery manufacturers in India have scaled down their operations and are moth-balling capacities to cope with the slowdown.  Till such time as the global economy gets back on track, the demand for jewellery will be tempered by the fact that the Indian economy is facing challenging times. And, if the rupee continues to weaken, gold prices will further increase.  India's growth rate will in all likelihood slip to around 4.5 per cent from the 9 per cent that was being clocked before the global financial crisis hit. Although India is not in a recession, the fear factor is making people cautious.

    The way ahead

    The above factors suggest that the unprecedented destruction of jewellery demand that is currently underway will trigger a correction in gold prices. Gold bulls, on the other hand, are convinced that increased investment demand for gold will compensate for the destruction of jewellery demand. In such an eventuality, gold prices will continue to rise as investment money continues to pour in.

    The further increase in gold prices will lead to the acceleration in demand destruction. As and when investment inflows abate or reverse, gold prices will correct. The further the rise - the steeper the fall.One consequence of the high gold prices is that the government of India has directed the Geological Survey of India to begin the groundwork for indentifying mining blocks for India's potential reserves of 20,000 tonnes of gold.

    The government is planning to open up its mining sector to private players to tap these reserves. This will impact gold prices in the long term.

    In the existing global financial environment, there is an element of risk in all asset classes, be it commodities, stocks or real estate. Even a traditional safe haven asset such as gold is not immune to risk.

    Especially because of the volatility brought about by the huge amounts of money that speculative hedge funds are able to bring into play. Investing in any asset class, including gold, should be a well thought out decision.

    To invest in an asset merely because it is recommended that a certain percentage of one's investment allocation should be to a particular asset amounts to investing one's hard earned wealth without doing the homework.

    The author has extensive experience in the jewellery retail and manufacturing business. Views are personal.

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    Chand Mehra
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