Gold Crash: Cause and Effect

alling gold prices boost demand in India

alling gold prices boost demand in India

Gold, the world’s most precious and desired metal, has been the fallback asset for both individuals and governments, through time, and the demand for gold remains unabated. Therefore, when international price of Gold crashed in a matter of seconds on 19 July 2015, the world sat up and took notice.

Earlier, mid-January 2015, saw gold touching a record high for the year at $ 1307/oz. and the world was all excited about the overall international economy showing signs of recovery, led by positive headwinds emanating from the US.

But then, on 19 July, when China opened for business, there was an unusual burst of frenzied activity on both the Shanghai Gold Exchange and Shanghai Futures Exchange, which together saw over 250 tons of notional gold being traded, which in turn throttled the price of gold to go south, forcing the authorities to halt the trading twice. The damage had been done, with the gold touching a 5 year low at $1080/oz. before finally making a slight recovery and settling at $1100/oz. In New York alone, traders saw over $500 million disappear in a matter of seconds.

Through last week, gold has witnessed its longest phase of continuous decline, not seen since September 1996. From the heydays of 2011, gold is now trading 40% lower.

Stock prices of gold manufacturers have been taking a beating as most have manufacturing costs of $1100/oz. and above. With gold trading at lower prices, most are already pressing the panic button.

This was not the first time this has happened nor will it be the last, but in between we must understand why gold nosedived at a time when the demand for it is apparently rising.

Understanding gold demand and behaviour

Gold is a perhaps the only metal through time that has managed to retain its aura with consumers, while governments continue to use gold as hedge against any sudden downturns in the domestic or international economy. Gold is viewed by governments as a hedge to a devaluing currency and inflation.

Trends in gold trading have always been independent of other metals. While most metals have seen price fluctuations on a regular basis, gold has been mostly steady in the last four decades and has been making significant gains, along with volatility, only in the last 5-8 years.

Gold trading involves buying and selling of ‘physical’ gold and trading of ‘futures’ in gold i.e. trading on a perceived value of gold in future. Futures in gold involves ‘notional’ gold that may or may not reflect the actual physical stock of gold or its present value. Futures are traded with a small fraction of the value of physical gold, with the majority price being dominated by its ‘paper’ value only.

Physical gold is traded at the Shanghai Gold Exchange (SGE), which is the only official ‘physical’ trading exchange for gold and also reflects the true value of gold being traded. On the other hand, COMEX in USA, along with the Shanghai Futures Exchange, is the dominant exchange where gold futures are traded.

The price of gold traded is usually influenced by several factors and is closely linked to the prevailing strength of the US dollar against major currencies, inflation, federal interest rates of major governments, and the prevailing geo-political scenario.

So what drove the markets to a dramatic crash on 19-20 July 2015?

Stakeholders and government officials are still trying to figure it out but the triggers must be understood at two levels – an intentional action on part of a section of traders to drive down the prices in the short-term, and the macro-economic factors that have influenced the rise of gold price this year and its subsequent drop.

First the intentional trigger. It is fairly obvious that certain hedge funds operating out of China and Asian markets dumped over $2.7 billion of gold triggering a panic and subsequent collapse, forcing a shut down by the authorities. What started in the Chinese exchange, was followed through on COMEX, resulting in gold dropping to record levels in five years.

Interestingly, the next three days saw physical gold buyers come out in full force to pick up gold taking full advantage of lower prices.

Who was really behind the sudden crash is still being investigated, but what needs to be understood is the bigger picture involving current macro-economic factors that influence demand and supply of gold. There are some possible explanations based on macro-economic factors.

The strengthening of the US Dollar

The strong US dollar has resulted in money shifting out of emerging markets like Brazil and South Africa and causing a pressure on commodity prices and making them more expensive, especially those that trade in the US dollar. This resulted in a demand drop in commodities. The currencies of emerging markets like the Brazil and Russia, and also countries like Colombia, have seen the value of their currencies erode by 30% in the last one year.

Fund flow data reveals international investors have been dumping gold and exiting emerging markets to the tune of $10 billion in the last two weeks alone resulting in the bear trends being presently witnessed. Going forward, the US dollar shall continue to remain strong through most of 2015 and the price levels of gold, is likely to recover to levels above $1200/oz., by the year end.

The China factor

China holds the 5th largest stock of gold and has emerged as the largest buyer in the world. Therefore, Chinese trends for either buying or selling gold influences the international prices for both physical gold as well as futures. Although, there have been doubts raised over the actual amount of gold held by China, the fact is that China is continuing to buy gold as has been witnessed in the last couple of quarters. In fact, the People’s Bank of China (PBOC) has ramped up its gold reserves by 57% from its 2009 levels.
However, what is worrying international investors is that the Central Bank in China has revealed buying gold at a slower pace. This, along with lower PMI figures being reported, is spooking international investors who have been moving out of gold to other asset classes.

But, with Greece moving towards resolving its financial problems and remaining in the EU, and sanctions on Iran likely to be lifted, the general optimism is likely to have a positive impact on demand for gold, at least in the coming two quarters.

Federal rates and inflation

The US Federal interest rates have a direct impact on inflation and the international community has been cautiously watching the numbers coming out of the US that indicate a recovering economy. This may just trigger an interest rate hike, which in turn will strengthen the US dollar that will only put pressure on the price of gold. However, if China and India continue to buy gold as in earlier levels, the price of gold is likely to counter balance any impact from the US Federal Reserve actions.

So what are the trends in demand for gold in India?

The Indian gems and jewellery industry has been suffering a double whammy – high interest rates and dropping gold price. In a bid to reduce Current Account Deficit (CAD), the government, in 2013, began to put curbs on gold imports. The banks increased lending rates to the industry substantially, which resulted in a significant drop in liquidity for the industry. This along with a 27% drop in gold prices in the last nine months, when gold was selling at Rs 34,000 per 10 grams, has caused havoc within the industry.

The Indian banks are under pressure for reducing NPAs, given the collective exposure to the industry hovering around Rs 250,000 lakh crore. With banks now refusing to replenish exporters the gold they have exported, along with dropping prices and high interest rates, there is a real possibility that at least 50% of the total loan exposure could turn into NPAs. That could well impact the government’s overall plans of achieving its fiscal targets for the year.

Deepawali which is seen as a traditional peak period for gold purchases by consumers in India, is likely to witness a subdued demand this year, further adding to the industry’s problems. The government on its part is trying to address the problem and with CAD under control, the government is likely to take measures to ease gold imports. How this will impact the Indian industry in the near term, remains to be seen.


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