Gold may be skating on thin ice

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De-hedging of the yellow metal may be coming to an end.

G. Chandrashekhar

Mumbai, April 3

It is by now well understood that the kind of price support gold received from continual de-hedging for the past 8-10 years may be coming to an end. Currently, the global hedge book is only 8 per cent of what it was in 2000. Other things remaining equal, this single factor would be negative for the gold market.

A view is now gaining ground that the negative effect of the virtual end of de-hedging would be largely neutralised by the official sector demand.

The official sector used to be net sellers of the yellow metal; but given the developments of recent months, there is widespread expectation that the official sector would generate net demand rather than net supply.

To what extent is this expectation realistic or justified? A couple of reasons are advanced for the change in official sector position.

One is from the supply side and the other from demand side.

As for supplies, the European central banks have, in the last couple of years, significantly slowed their annual sale of up to 500 tonnes that has been agreed. This has given rise to speculation that the annual sales volumes will continue to fall much below the permissible quota.

Sales volume bullish

On the other hand, there is a certain bullish expectation that some of the central banks around the world with large foreign exchange reserves of dollars would be keen to diversify their holdings by buying gold. Emerging markets, especially in Asia, seem to be in line.

India's purchase of 200 tonnes from IMF and smaller quantities by Sri Lanka and Mauritius late last year has heightened the expectation that more such transactions would take place.

Two issues need attention. One is that there is ‘sale' of gold by the IMF and the second is that it is a paper transaction rather than transfer of physical gold. Because it is an off-market transaction, normally it should be neutral for the physical market. However, it has had a sentimental impact on the market because it involved purchase by a central bank.

Foreign Exchange

Major Asian economies such as China continue to accumulate huge foreign exchange reserves which gives rise to speculation that the country may want to diversify further by buying gold. Already the Chinese currency is under intense pressure for revaluation; and there are signs the Yuan will strengthen over time. In the event, the pace of foreign exchange inflows or accumulation may slow down.

While the importance of asset diversification is well understood, one cannot overlook the fact that China has been buying gold from its domestic sources for quite some time rather than from overseas. Speculation in recent weeks of China buying the balance 191 tonnes out of IMF total gold offerings of 403 tonnes has remained just that – speculation.

So, much of the hype about continued official sector demand is speculative rather than based on any tangible evidence. It is likely that the lobby of gold producers may be creating a frenzy about likely net demand from the official sector merely to keep prices well supported.

Physical demand

Physical demand is far from robust. High and volatile prices are seen driving consumers away. Investors will of course continue to participate; but to an extent even investment demand is fickle. Less-committed investors are the first to exit the market.

So, it stands to reason to believe that gold is actually skating on thin ice. If and when the equity markets begin to perform more robustly, flight of investment funds cannot be stopped. Commitment of Traders report issued by the US market regulator needs to be watched closely for signals.

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(This article was published in the Business Line print edition dated April 4, 2010)
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