The important linkage of gold with the global financial system enhances the role it can play in the overall development of an economy.
The essential and irreplaceable function of gold in the global financial system is money. Gold exists in a relatively fixed supply and is the only currency that cannot be inflated at the discretion of political and economic advantages.
It is a true store of wealth, unlike the paper currencies that can be created in unlimited quantities. Gold can be over or undervalued by investors at any point in time, but over the long-term, its purchasing power remains stable.
Demand for gold arises from consumers in the form of jewellery, dental fillings, and other uses; from industry as one of the most ductile metals and as an excellent conductor of heat and electricity. Also the demand arises from central banks as per cent of their reserves, and from investors and speculators as a store of value and as an investment.
The supply of gold arises from mining, refining of re-cycled gold, sales by central banks and investors. Around 68% of gold demand is jewellery, 13% is industrial (dental, electronics), 11% is investment (institutional and individual, bars and coins), and 7.2% is from ETFs and other similar products.
The main reasons why gold finds a place in the investors' portfolios are (i) gold has historically proved to be a good hedge against inflation, (ii) it is highly liquid asset and (iii) It has ornamental value (more so for Indians). On the other hand, there are certain disadvantages attached to gold investment.
For instance, it does not provide regular current income flow like equity (dividends) and bonds (interest). Likewise, it does not offer any tax advantages which other investment instruments can offer (e.g. infrastructure bonds).
Furthermore, there are certain issues regarding the purity of gold, which can not be easily ascertained by a lay man and there could some storage cost involved in keeping gold.
But some of the disadvantages have been addressed by the recent advent of Gold ETFs.
It can be ascertained that gold is in the very beginning of a multiyear bull market that will take the yellow metal much higher from the current level ($ 870). There are so many factors which are in favour of higher gold prices.
Either it is recession in US (decreasing interest rates and increased money supply) or boom in US (increased demand and its impact on emerging markets, easy monetary policies) gold has to go up.
There may be some short term corrections in the gold prices but these corrections should be captured strategically to accumulate gold at lower prices.
Assuming the Chinese and Japanese continue to support the dollar to some extent, the main fundamental driver for continued increase in the gold prices will be monetary inflation in the US (M3).
It may be mentioned that in the late 1990s and early part of this decade, the gold prices were well below its cost of production for many consecutive years but now sells at a price that is nearly double its cost of production.
Both of these facts indicate that marginal cost economics do not determine the market price of gold. Ultimately, the value of gold in US dollars rises or falls because the US dollar monetary base expands at a faster or slower rate than the global gold mine supply.
S P Sharma is Senior Research Analyst with IL&FS Investsmart Commodities Limited
