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Aarati Krishnan

Over the years, retail gold buyers in India, if not its stock market investors, have adhered quite faithfully to the cardinal investment rule that says “buy low and sell high”.

Retail demand for jewellery in India has usually dwindled every time the price of gold has spiked and picked up whenever it moderated.

Yet, India’s central bank has chosen to ignore this tenet when it recently bought 200 tonnes of gold from the IMF through off-market transactions at market-based prices.

After all, the timing of the deal can hardly be called ideal. It was put through shortly after global gold prices had sailed past their previous lifetime high of $1030.8/ounce, last attained in March 2008.

Probably why one senior IMF official has been quoted as saying that the institution has been “lucky” in putting through the gold sales at roughly $1,045 an ounce, compared with $850 an ounce in April 2008.

So, what is the rationale for this purchase? The central bank has provided no explanations, only stating that the move was part of its foreign exchange management operations.

The Finance Minister, on his part, has sought to give it a patriotic twist, talking of how this purchase has provided a healing touch to the country’s sentiments, which were ‘outraged’ when the central bank pledged gold to the IMF in 1991 to raise short-term funds.

However, if that were the reason; the transaction comes several years too late.

By holding its gold reserves almost steady over the past five years, India has already missed out on a good part of the multi-year gold price rally which has taken the yellow metal’s prices up from about $500 to an ounce in 2005 to over $1050 now.

Gold prices today are at roughly three times the levels in 1991, when India pledged its gold holdings.

Having said this, the logical reasons why the RBI, as the fund manager for the country’s foreign exchange reserves, would seek to swap dollars for gold, could be to either diversify or re-balance its reserves.

The dollar’s renewed slide and worries about the US economy slipping back into recession have once again resurrected predictions of the currency’s demise and cast fresh doubts on its status as the reserve currency of choice.

Gold’s proven negative correlation with the US dollar makes it a good option for investors wishing to diversify their portfolio from the currency. It may even be a better alternative to currencies such as the Euro.

The IMF sale, by offering RBI the opportunity to boost its gold reserves by 55 per cent at one shot, allows it to take the proportion of gold holdings in the forex reserves to roughly 6 per cent. That may still not provide much of protection against a steep slide in the dollar; but it is some shield nevertheless.

Even if this move is motivated by long-term considerations, it may expose forex reserves to the risk of greater short-term fluctuation. By placing its bets on gold in place of the dollar, the RBI is essentially taking the call that gold prices will protect value better than the dollar. However, there are really no fundamentals to back the view that gold is still under-valued at its current price.

Stocks or bonds have underlying financials which can be used to arrive at intrinsic worth. In contrast, gold prices are purely a function of demand and supply, with an overlay of speculative forces. The bullish price “targets” for gold now doing the rounds in the market are either based on technical analysis (a function of momentum) or on its previous high, adjusted for inflation.

Gold’s price history suggests that the downside in gold prices, if they correct, can be much sharper than that in the dollar.

Over the past five years, the worst monthly performance from the dollar was its 6.2 per cent drop in May 2009. However, gold prices declined a whopping 18.4 per cent during the yellow metal’s worst month — October 2008!

More Stories on : Gold & Silver | RBI & Other Central Banks | Insight | Financial Policy

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