India’s purchase of 200 million tons of gold from the IMF in early November marked a turning point for the gold market. For years central banks have been net sellers of gold in the belief that gold no longer functioned as a monetary reference point.
The argument went that there is so little gold relative to all notes on issue that it could not serve as a base for even one of the minor currencies, let alone the major ones. It would be like a thimble representing the value of an office tower. Gold also created no income, was costly to store and had limited industrial use. It was more a “belief” more than an asset. Gold was redundant now that economists had abolished the business cycle and could manage economies well.
Consequently many central banks (except France and the US) ran down their gold holdings. The UK led the charge selling 400 tons between 2000 and 2002 at an average price of $375 dollars. Since then the gold price has tripled and the UK is now in a very troubled state. Just like the US it failed to supervise its banks; it attempted to rescue them by expanding the currency base; it has a rising trade deficit, declining energy resources and ballooning debt. In contrast the countries believing in gold have one asset that has risen while their sophisticated assets, Dollars and Treasury Notes, have lost value and may lose more if inflation takes hold.
India’s changed view still leaves much scope to add more gold as gold still represent s only 6.4% of its total foreign reserves. China’s has just 1.9% in gold and over two trillion in US “near cash” securities that pay little interest. This is why many like Merrill Lynch believe gold will continue to rise. They argue:
1. The financial crisis led to the creation of one trillion rescue dollars to prevent a collapse of the world financial system. While this “quantitative easing” (printing of notes) saved the situation, the US banking system is awash with dollars waiting for suitable investment.
2. As money is lent it circulates so that effectively each dollar is lent several times.
3. This monetary creation allied with the “velocity” of money sets up the risk of high and sustained inflation.
4. The fear of US inflation has led to a fall in the $US dollar rather than a rise in gold.
5. This is demonstrating that gold is a now a safer store of value than the US dollar.
But does it always follow that the printing of money leads to rampant inflation? It doesn’t if demand for goods is constrained by excess supply. There is little inflation in the US at present as supply of goods is greater than demand. There is over-capacity in housing, vehicles, commercial property IT etc. However, the concern is that gradually demand will rise. Interest rates are low and the slump of the dollar assists US exporters to sell aircraft, software, chemicals, food etc. As activity rises the trillion sitting in banks will start to circulate through the system. Banks will need to lend to rather than make money by trading securities .
The US could lift interest rates to curb activity but with 10% unemployment this will be delayed as long as possible. The concern about the weak economy behind the US dollar seems to be a stronger force on gold than fear of inflation. But there is a third pressure as well. That is the supply of gold itself. As the chart to the right shows, gold production has been falling since 2000. Peak supply was nearly 2600 tpa. Today it is around 2400 tons being the net effect of sharp reductions in South African supply, now down 75% since 1970, and the rise of Asian and Central Asian supply. West African supply is also tending to compensate for the closure of several deep South African mines which are becoming uneconomic at five kilometres below surface. China’s largest gold miner Zijin says China’s own reserves will last for only another 7-8 years. More optimistic reports suggest 10-15 years. South Africa’ may have than ten years of current output. The 120 year old Witwatersand fields now operate at 3km depths costs which raises are high despite low labour costs. The South African Journal of Science carried a rec ent report suggesting Rising power costs may be mean over half of this remains in the ground.
The fall in world in supply is not due to lack of effort. Gold has been rising for 6-7 years ample time to put open cuts and mid-size mines into production. The problem is falling grades. As the CEO of Barrick, the world’s largest gold producer, said recently average grades in the US, Canada and Australia were 12 grams per ton in 1950; today the average is 3 g/t. To demonstrate its belief in “peak gold” Barrick will spend $5.7 billion closing out its hedge contracts which require it to sell gold well below current market prices. Newcrest and others have closed out their hedges as well, effectively showing their conviction that the gold price can only rise.
As we have seen there are pressing monetary reasons for gold demand, but investment demand is also on the rise. Exchange traded gold funds now account for almost a sixth of annual gold demand as the private investor buys gold indirectly across many markets. The Gold Council’s ETF, now holds 1,100 tons of gold, more than many countries.
The one obvious negative for gold is retail demand. India’s jewellery trade normally consumes about 25% of world production, but retreats when the price rises. This month buying has slowed, but bullion funds are more than compensating. The lifting of restrictions on private Chinese buying is also likely to have a large and growing effect. China’s potential demand is immense. If just 1% of Chinese bought an ounce of gold each that alone would be over one sixth of annual production.
This amounts to a very strong case for gold: rising physical demand, falling production and insurance against both currency instability and mid-term high inflation.
R.M Campbell 25/11/2009
