Will the gilt trip continue?

In order to understand the dynamics of gold pricing,first remember that most of India8217;s demand for gold is met through imports. Hence,we are price-takers,i.e.,prices in India depend on international prices. Only sometimes,when a lot of recycled gold comes into the market,are prices in India lower than international prices.

In addition to international price in dollar,the price in India also depends on the movement of the rupee against the dollar.

The demand for gold emanates primarily from three sources: jewellery,investment and industrial. Of these,jewellery demand is the most important,investment demand comes next,and industrial demand is much smaller.

Jewellery demand is driven by economic conditions and prices: adverse economic conditions and high prices,as existed last year,affect demand adversely. Investment demand depends on sentiments. According to Pune-based financial planner Veer Sardesai,8221;The investment demand for gold derives from the fact that it is perceived to be a safe haven. When the economy is in doldrums,stock markets are falling,and property prices are declining,money flows into gold.8221; All these factors pushed up investment demand in late 2008 and early 2009.

Explaining why the price of gold reined high in 2009,Ajay Mitra,managing director,World Gold Council,India subcontinent,says: 8220;During recessionary periods,consumption spending tends to fall,but investment demand for gold increases. This helps balance any impact on price that lower jewellery demand would have.8221;

Moreover,at a time when the dollar was weakening,demand for gold came from a new source. 8220;For the first time in over a decade,central banks turned net buyers of gold. Central banks are looking for ways to diversify their dollar exposure. Gold is a clear beneficiary of this trend,8221; says Mitra.

Outlook for 2010

Let us look at both supply and demand related factors to determine how gold is likely to fare in 2010.

Supply-related factors

Mine production. The largest element of supply,it has been declining since 2001. It fell by 3 per cent last year,to 2,400 tonnes. Says Mitra: 8220;In the late 1990s there were considerable cutbacks in exploration spending due to the low price of gold then,hence there has been a dearth of new discoveries. Declining ore grades and production disruptions are also responsible for declining supply. Since 2004,exploration spending has increased sharply,but the industry has not been successful in making major new discoveries. Besides,it takes six-eight years from the time of discovery to bring that a new finding of gold into the market. So even the few discoveries made in the past two years are unlikely to affect supply in the near future,8221; says Mitra.

Recycled gold. Because gold is virtually indestructible,practically all the gold that has ever been mined still exists. The best estimate of above-ground stocks is 1,63,000 tonnes. A large portion of it resides in the form of jewellery in India. During times of high prices,this gold comes back into the market. 8220;The combination of the global recession,record high gold prices,and high levels of price volatility saw scrap supply surge during the latter part of the financial crisis. That has,however,eased lately. Provided the economic recovery continues,distress selling of gold should continue to ease in 2010,8221; says Mitra.

Official sector supply. After being net sellers of gold for decades,the official sector turned a net buyer of gold in the second quarter of 2009. That reflected two developments: slowing sales by European central banks and significant purchases by Asian central banks. European central banks had been selling approximately 400-500 tonnes of gold a year for the past 10 years. Last year,however,their sales slowed down to just 155 tonnes. Meanwhile,the central banks of China,India and Russia turned purchasers,buying 450 tonnes,200 tonnes and around 120 tonnes respectively. 8220;Were Asian central banks to increase their holdings by just 1 percentage point,they would need to buy 1,000 tonnes of gold. Official sector activity will be a key variable to watch in 2010,8221; says Mitra.

What needs to be seen is whether the dollar will continue to weaken. And if it stops depreciating,will central banks want to purchase more gold?

Demand outlook

Jewellery demand. Year-on-year world jewellery demand in terms of tonnage was down 20 per cent for the 12 months ended September 2009,and 30 per cent in Q32009. The outlook for 2010 remains cautious. With the price of gold having increased further,jewellery sales are likely to continue to struggle in most countries except China.

Investment demand. For the 12 months ended September 2009,total identifiable investment demand which includes gold coins,gold bars,gold exchange traded funds and other products was up 69 per cent year-on-year. But as the economic recovery gathers momentum,this demand may not remain as strong. In perhaps a harbinger of things to come,investment demand fell 46 per cent in Q32009 compared to Q32008.

What should you do?

With gold prices reining high,it is difficult to see jewellery demand recover very soon. Investment demand,too,may weaken as the world economy recovers. Investment demand also gets adversely affected by high prices. Unless central banks act hastily and withdraw the stimulus an unlikely prospect the developed world is likely to see a slow and long-drawn recovery. Developing economies like China and India are already on their way to achieving the trend level of growth of the past five years. 8220;As the economic environment improves,money moves out of gold and into riskier asset classes such as stocks,real estate,and so on. This is what is likely to happen in 2010,8221; says Sardesai.

As for the likely returns from gold in 2010,Sardesai says: 8220;It is unlikely that the 25 per cent returns seen last year will be repeated. Since gold has already run up quite a bit in the last two years,to expect a high return from it over the short term would be over-optimistic.8221;

Over the very long run,meaning decades,the returns from gold just about manage to beat the long-term average rate of inflation by about 1 per cent. Thus,in India,if the long-term average rate of inflation is about 7 per cent,you should expect a return of around 8 per cent from gold over the long term.

All this,however,does not imply that gold should have no place in your portfolio. According to financial planners,it should constitute at least 5 per cent of your portfolio more accurately,your financial portfolio,excluding your real estate holdings.

According to Pune-based financial planner Veer Sardesai,8221;Gold should be held in your portfolio to serve the purpose of a contingency reserve. In times of war and other extreme calamities,gold is one asset that retains its value.8221; In such times,the stock markets could stop functioning and it is also improbable that you will be able to liquidate your real estate holdings for cash. During the time of the Partition,says Sardesai,when a large number of people had to flee across the border,gold was one asset that they could carry with them on their person. One could argue that the Partition took place a long time ago and that such extreme circumstances are unlikely to be repeated. More recently,during the East Asian crisis,the currencies of many nations in the region lost value drastically. Gold,however,retained its value in dollar terms.

Moreover,gold is a highly liquid asset. In case the breadwinner of a family passes away suddenly,even the housewife can take her gold holdings to the nearest jewellery shop and exchange it for cash. This will help her tide over the temporary cash crunch till payments from the insurance company and other financial assets come through.

For gold to serve its role as a contingency reserve,however,it must be bought in the physical form and not as a financial instrument such as an exchange traded fund.

If,at present,the amount of gold in your portfolio is less than 5 per cent,this is as good a time as any to buy gold since you will be holding it for a very long time.

How to buy gold?

If you are buying gold primarily as an investment,then do not buy it in the form of jewellery. 8220;You will have to pay making charges when you buy it,which could push up the price by as much as 25 per cent higher than the price of bullion. And when you go to sell it,the jeweller will deduct the making charges. He will also dispute the quality of gold,8221; says Sardesai. Instead,he suggests,buy it in the form of bullion either as gold bars or gold coins. Financial planners suggest that you go to a well-established jeweller and ask for gold coins certified by banks. If you buy from a bank,it will charge you a premium for the same coins.

Buying gold in the form of units of exchange traded funds ETF has gained popularity in recent times. The advantage here is that the purchase process is easy: all you have to do is call up your broker or place the order online. And you don8217;t have to worry about theft. The purchase cost is as follows: you pay the stock broker8217;s brokerage fee 30 to 50 basis points and in addition you pay the ETF8217;s annual expense ratio of 1 per cent. However,when you buy gold in the form of a financial product,remember that it will not serve the purpose of a contingency reserve in extreme circumstances.

Thus,while gold may not offer you very high returns this year,it should continue to occupy a small place in your portfolio. u

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