Sunday, September 11, 2011

What does rising Gold prices mean?

Gold has been one of the best performing assets over the last year, as prices have skyrocketed to record levels. It seems as though a new record in prices is set nearly every week, and the trend appears set to continue going forward.

So how can we interpret the rise in gold prices? There are two issues to discuss here. The first is, why is it that investors want to buy gold, and the second is, what is the impact of rising gold prices on the rest of the economy.

The two issues are obviously linked, but let me attempt to look at each one in turn.

Investors buy gold primarily as a safe haven. Gold is known to perform well when the rest of the economy is in a poor state, and thus investors buy gold to protect themselves financially. Thus, we see gold prices rise whenever there is uncertainty about economic prospects or in financial markets. For example, both the American and European debt crises have led to increases in demand for gold. From this perspective, we can interpret the rise in gold prices to mean that investors are worried about economic prospects, particularly the global economy. As gold is an internationally traded commodity, its movements are driven by global rather than local factors. So rising gold prices does not necessarily mean that Indian economic prospects are poor.
The second reason investors buy gold is to protect themselves from currency debasement. In general, central banks can print as much money as they wish and inflate away the value of the currency. On the other hand, gold cannot be created at will, and so its value should rise if excess currency is printed. Gold prices have increased whenever there has been talk of quantitative easing by the US Federal Reserve, as this involves printing dollars. From this perspective, we can interpret the rise in gold prices to mean that investors expect future inflation to be high. That is, they expect that current money printing by central banks will lead to higher inflation in the future, as the fiat currency is debased. Lower interest rates have also contributed to higher gold prices, as this also creates additional cash in the system. To summarize, rising gold prices mean that investors are fearful about economic prospects and are fearful about excess inflation or devaluation.

One factor that is very interesting and perhaps inconsistent with the above explanations is that Indian investors are leading the way in gold buying. That is, much of the gold demand is coming from investors in India. This is puzzling for two reasons.
First, prospects for economic growth are fairly strong in India, as compared with the rest of the world. Economic growth has been slowing, but it is still above 7%, and well above growth rates in most other countries. In addition, India does not face the same debt problems that Western economies face, and so safe haven concerns are minimal. Second, the RBI has been raising interest rates and tightening monetary policy. In an attempt to reduce inflation, the RBI is reducing the amount of rupees in circulation. This should mean that in rupee terms, gold prices should be falling rather than rising, however the opposite is occurring. Hence, the fact that gold demand from India is strong runs contrary to the usual explanations for rising gold prices. The most we can extract from the high gold demand coming from India, is that investors are fearful that the Indian economy will suffer if the rest of the world suffers, and for this reasons it is sensible to buy gold. The current economic situation does not justify increased safe haven demand, but perhaps the future economic situation will, and thus it may be sensible to buy gold now.

We can interpret higher gold prices to mean that investor confidence is low. That is, investors are not particularly confident about future economic prospects, even domestically. Let's consider the impact of rising gold prices on the economy. In general, the impact is negative. This is for a few reasons. First, the more money investors are putting into gold, the less money investors are putting into businesses and productive investment. Money invested in gold does not create output or employment, whereas money invested in businesses in the economy would do so. Thus, investment in gold is negative for economic growth.
Second, as India imports its gold, the more money investors put into gold, the worse the current account deficit becomes (that is, the wider becomes the gap between imports and exports). This also is negative for growth, as imports are subtracted in the calculation of GDP. Finally, and this is perhaps the most important factor, investment in gold is a sign of low confidence in the economy, as discussed previously.

Low confidence in the economy can itself hurt economic growth in a significant way, as people put off making investments and making large purchases. As long as gold prices are rising and investors are fearful about economic prospects, the impact on the overall economy will be negative.

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