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To Gabrielle, David and Sarah, my three golden nuggets.


Foreword

Writing a book on gold in 2014 feels like writing “Dow 36000!” in 2001 after the market had crashed. Of course, market moves during the past decade provided a strong motive to look in detail at “the barbaric relic”, remove misconceptions and present the analysis to a large audience. Rather, the genesis of this treatise traces back to a discussion in 2009 between an Indian-born eco-nomic geologist and a Swiss-based investment strategist. Simply put, a gathering of a father and his son.

The love for gold has been universal – except with economists. It has appealed to human beings irrespective of their origin, color, race, religion, and sex. This book does not provide any justifica-tion for the use or the value of gold; the study here, rather gives an understanding as to role of gold in society and focuses in how its price is set, even if it often generates seemingly irrational be-havior. Indeed, irrational behavior is often denounced by the economists, who tend to see gold as being useless and unproduc-tive, creating no value, generating no income and even being simply “barbaric’. We believe and will demonstrate that there is much more value in gold, which might be one of the very last, rationally priced financial assets.

We took pleasure in bringing a unique perspective on gold in-vesting. Indeed, this work should contrast with many existing books relating to gold investing, because

It presents an analytical framework for gold valuation,

It details winning investment strategies, and

It keeps a non-US centric international perspective.

On the contrary, most common approaches are done for US-based investors with a pure USD reference, and they often fail to rationalize gold investing into a testable framework. As a result, gold prices are explained by anecdotal and un-testable random factors such as psychology, one-time events, chartist techniques, etc. This lack of rigor in the field of gold investing has open a void

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for dubious rationale, most often flirting with conspiracy theo-ries, which in the end absurdly justifies purchasing gold at any prices...

This book is presented in four distinct sections. The first part presents the context of rising global liabilities that questions the resilience of traditional safe assets and highlights the current relevance of gold investing. In short, slow-to-moderate growth is largely supported by active public policies, generating large pub-lic deficits and negative real rates from easy monetary policies. By itself this backdrop is conducive to a medium term apprecia-tion of gold. Moreover, there are growing “tail risks” when con-sidering all options. Indeed, it is also possible that governments will renege on their obligations. With the risk of being provoca-tive there is a distinct possibility that the US Treasury could de-fault1 towards foreign creditors in the coming decades, with gold an undisputed hedge against it.

The second section explains the dynamics of gold prices. Gold prices are set simultaneously on three separate markets:

1. The commodity market,

2. The currency market, and

3. The financial assets market, because its value is also de-fined as an asset relative to main asset classes.

We believe that the currency market matters the most because gold is first and foremost a mean of exchange and a store of value, which lends credence to John-Pierpont Morgan’s blunt view that “Gold is money, the rest is credit!”

The third section of the book is pragmatic, focusing on invest-ment opportunities derived from this unique asset. Practical ex-amples of successful investing are presented with simple prediction-free frameworks for asset allocation, tactical, trading and relative value investments. Then, major instruments for gold investing are listed and it concludes with a professional inves-tors’ perspective.

The fourth and last section of the book is mostly descriptive and deals with the characteristics of gold. Gold is defined and de-scribed here from multiple angles: metallic, mineralogical, geo-logic, historic, social, economic and financial, enumerating its

1 Defaults is here be defined as the failure to meet the legal obligations and/or condi-

tions of a loan, nor the failure of a government to repay its debt



Gold investing handbook

7 Full version available HERE© Mourtaza Asad-Syed

conventional and modern day uses. The numerous facets of gold help understand its place in society through time and geogra-phies with some amazing facts.

The author sincerely hopes that amateur geologists, journalists, economists, analysts, traders, portfolio managers, institutional investors, retail investors and men and women fancying gold, should all find their subject of interest in some part of this work. To close, here is the best definition of gold: An ounce of which provides a perpetual and universal insurance to acquire a year of subsistence.



Content

Foreword .................................................................................. 5

1. Gold in a world of liabilities ................................................. 11

2. Valuing gold ........................................................................ 29

Overview .............................................................................................. 29

Gold as a commodity ........................................................................... 31

Gold as a currency................................... Error! Bookmark not defined.

Gold as an asset ...................................... Error! Bookmark not defined.

3. Investing in gold .......................... Error! Bookmark not defined.

Gold investing frameworks ..................... Error! Bookmark not defined.

Market characteristics and investment vehicles .... Error! Bookmark not defined.

Summary on instruments to trade gold .. Error! Bookmark not defined.

Professional gold investors ..................... Error! Bookmark not defined.

4. Definitions & overview ................ Error! Bookmark not defined.

Physical Properties and Attributes .......... Error! Bookmark not defined.

Psychological aspects .............................. Error! Bookmark not defined.

Use of gold .............................................. Error! Bookmark not defined.

Historical social and monetary functions Error! Bookmark not defined.

5. Conclusion and outlook ............... Error! Bookmark not defined.

Bibliography on Academic studies ... Error! Bookmark not defined.

Glossary.......................................... Error! Bookmark not defined.

Table of contents ............................ Error! Bookmark not defined.

Table of figures ............................... Error! Bookmark not defined.

Acknowledgements......................... Error! Bookmark not defined.


1. Gold in a world of liabilities

Gold’s ability to protect wealth from government confiscation or spoliation makes it imperative to examine gold investing over the next ten years. During the past ten years, gold rallied against major currencies as real rates declined and remained low. Given current levels, real rates cannot go much lower, and hence cannot provide support to a gold rally of similar magni-tude as in the past decade. While gold has declined in 2013 by 26 percent and may not have strong absolute performance ahead, we nonetheless see potential for gold to perform well against OECD government bonds. In the coming ten years, ex-cess public debt in the Eurozone, Japan, the UK and the US will translate into capital losses on private savings. Indeed, the only feasible end game for public debt sustainability is a forced transfer of the capital loss burden to households or to foreign-ers.

Gold investing is often anchored on distrust of government, be-cause governments abuse their right to print money. Currently, economists are worried about deflation, but many long-term in-vestors are already speculating on inflation or even hyperinfla-tion, and while these are legitimate risks, a savvy investor needs to consider another risk that has not been highlighted in previ-ous discussions: Spoliation! Namely, the effective plundering of foreign holders of US assets and European pensioners! The start-ing point of these man-made-disasters is the dire state of OECD public finances. Indeed, the state of public finance and the fore-seeable patterns for government liabilities are unsustainable around the globe, and this imbalance clearly opens the door for unorthodox policies that could well impair investors.



Dire public finances in the Eurozone, Japan, the UK and the US

Following the credit crisis of 2008, public debt across the OECD expanded massively to substitute for private sector deleveraging in an attempt to soften the economic recession. This would be sound policy if public finances were not already impaired by ‘off-balance sheet unfunded liabilities’ caused by pension obligations and other benefits (such as health coverage) for a cohort that is benefiting from an unprecedented increase in life expectancy, not offset by adequate population growth. Given the severely im-pacted public finance situation, adding additional debt is effec-tively kicking the can down the road to a future generation.

There are three ways for the government to reverse the course of the public debt spiral:

A growth strategy: Induce growth to dilute the debt-to-GDP ratio with higher revenues,

A monetary erosion/inflation strategy: Create inflation, to erode the nominal value of existing debt

A write-off/default strategy: Use default or restructuring to cancel or reduce the obligations promised either to its citizens or foreign creditors

So far, Anglo-Saxon countries, chiefly the US, are aiming at the

growth strategy, pushing for a super easy policy-mix.(i.e. fiscal and

monetary policies) Continental Europe is pushing peripheral Euro

countries to default on obligations to their citizens in the form of

austerity policies that reduce the benefits received by citizens. No

explicit strategy was discernible for Japan, until the recent change in

Bank of Japan (BOJ) leadership and Prime Minister Abe’s economic

program that one might broadly categorize as their pursing a credible

growth or even an ‘inflation’ strategy.

Growth strategy: a risky dream

The growth strategy is the most seductive and the least painful for citizens, creditors, and politicians. This high return strategy is also high risk because if it fails, the country is stuck with an even larger public debt (left by active fiscal policy) and has no monetary lever left. In the US (and the UK), monetary authorities have even jumped into vigorous monetization of public debt, in the name of quantitative easing (QE). Historical experience has





shown that monetary misconduct is usually perpetrated for fis-cal motives and leads to inflation (or hyper-inflation). Once cen-tral banks have locked short-term rates at zero percent and suppressed the entire yield curve below 2%, loaded their bal-ance sheets with Treasury bonds and become recurrent buyers, and provided commercial banks with immense liquidity facili-ties for any eligible collateral, it will be very hard for them to re-verse course! These actions put overall economic activity at high risk and threaten the refinancing abilities of their own govern-ment. Recently, even an “orthodox” central bank such as the Eu-ropean Central Bank (ECB) had to reverse course in the wake of the government debt crisis, and had to decrease rates and even commit to buying government debt. Interestingly, it was the ECB’s own tight policy in 2008-2011 that worsened Eurozone peripheral financing conditions and endangered the solvency of the weakest. In the end, when the solvency of a government is at stake, notions of central bank independence or restricting them to a solely inflation mandate is more theoretical than anything else, and even the ever conservative Germans had to swallow the broadened mandate of the ECB!

(Hyper) Inflation: a rampant nightmare

We explain below why inflation does not represent a govern-ment strategy per se, but could become an unintended conse-quence if the growth strategy fails.

An inflation strategy is not ‘politically’ viable. Most of the in-flation impact is domestic, especially for a country that is quite closed, like the US. External impact usually comes in lieu of a de-cline in exchange rates, but often only over the medium term. Domestic impact manifests itself either in a price-wage increase spiral, as rising cost of living can transmit into salary increase or simply loss of purchasing power when wages fail to match the inflation increase. Inflation above 5% to 10% is very unpopular, especially within the older cohorts who have little hope for fu-ture wage increases and are focused primarily on maintaining the standard of living during retirement. Rising or simply high inflation is among the worst enemies for any political incumbent. Indeed –even more than rising unemployment– an inflationary environment has sealed the fate of most unfortunate political leaders of the 1970s in the OECD (Carter, Heath, Wilson, Calla-ghan, Giscard d’Estaing, Andreotti…), and still dictates the win-ner in elections in emerging markets, in Latin America




especially. Within developed countries, only military casualties have a greater effect on the popular vote2. In most cases, inflation is associated with impoverishment within the working class be-cause it translates most into relative loss of purchasing power, and is perceived as a tax, since most blame government action (or inaction) for any rise in inflation. Any inflationary strategy to lower a debt overhang would carry high political risk, and would deter any public leader from pursuing this approach. It is no sur-prise to see that inflation is lowest in countries where leaders are more accountable to their people (i.e., the more democratic regimes). This is quite explicit in Figure 1.1 which demonstrates average inflation by political regime as defined by The Econo-mist. In 2010, countries with full democracy (Sweden, Norway, UK…) experienced an average inflation of 2.2%, while authori-tarian countries (Nigeria, China, Azerbaijan…) had on average 7.4% inflation. As a political choice, inflation will not be favored by any OECD government.

Figure 1.1: Inflation by political regime

Source: The Economist, World Bank, Wikipedia, Author’s calculations, Data as of 2011

A burst of inflation will not dilute the debt level as much as expected. During increasing inflation, even with a lax central bank that does not increase short rates, the yield curve tends to

2 See “Bread and Peace” model by Douglas Hibbs - University of Gothenberg

7.47.1

5.1

2.2

53 33 52 26

Authoritarian Hybrid regime Flawed democracy Full democracy

Average Inflation Number of countries



http://www.douglas-hibbs.com/



steepen with rising long-term rates. The term premium then in-creases, and stays higher for a while, often at least long enough to match the average public debt maturity, which means that the entire debt will end up being refinanced at a higher cost. As a result, during high inflation periods, long-term real rates are rarely negative and any gain from the dilution of debt by higher nominal GDP is offset by higher interest rates. Active quantita-tive easing from central bank could maintain a depressed long-term rate and contain increasing debt service, but this would need large amount of purchases at the issuance (primary mar-ket), which would breach all rules of sound monetary policy, and open the door for monetization and absolute loss of confidence in the currency. The other issue with generating such inflation is the side-effect on agents that have liabilities linked to inflation. For instance in the US, the Treasury issued USD800 billion of in-flation-linked bonds, and these bonds would not benefit from such policies, but it amounts only to 5% of total debt outstand-ing. Second, US Social Security has defined benefit obligations to future pensioners, linked to inflation, worth trillions of dollars that is guaranteed by the government. The Social Security Trust Fund’s current fund is about USD3 trillion (highly invested in Treasury bonds), which is about 20% of public debt. Therefore the impact of inflation would be null in terms of reducing the burden of the government towards the beneficiaries. The private sector too, has liabilities linked to inflation, which could create more distress and distortions than it cures. For instance, UK pub-lic sector pensioners are protected against inflation, whereas private sector pensions scheme have inflation caps.

Inflation is not in the DNA of Anglo-Saxon (free-market) countries. Market-friendly or capitalist countries such as the US and the UK do not favor inflation for philosophical reasons, mostly because it usually erodes value for owners of capital and forces redistribution of wealth, or at least equalization. It can also be argued that inflation is a consequence of redistribution policies not the cause. Indeed, social spending and welfare used to have a high multiplier effect on aggregate demand, which would lead to upward price pressures. Regardless of causation, it confirms the notion that inflation is related to a crucial social and political choice. Historical data displayed in Figure 1.2 (In-flation & income concentration) shows that in the US, inflation patterns play a significant role in income distribution, second




only to taxation3. As for advanced economies; high inflation has been experienced more in continental countries, such as Ger-many, Italy, France and even Japan. It is surprising to see that no Anglo-Saxon dominions (Australia, Canada, New Zealand, and South Africa) have experienced hyperinflation or simply very high inflation, when major European ones have experienced multiple inflationary bursts. One conclusion from Bernholz (2003), and highlighted in Figure 1.3, is that hyperinflation hap-pens only in regulated (e.g. centrally planned) economies. Free-market economies might be prone to financial bubbles, crises and deflation, but they seem immune to hyperinflation risks.

Figure 1.2: US inflation and income concentration

Source: Piketty & Saez, US Bureau of Economic Analysis, Author’s calculations

3 "The Effect of Marginal Tax Rates on Income: A Panel Study of 'Bracket Creep'" Em-

manuel Saez, Journal of Public Economics, 87, 2003, 1231-1258

20

2222

1514

13

1099

1110

11

2233

45

9

7

5

12

1

201020052000199519901985198019751970196519601955

Top 1% share of national income (%) Inflation (%, 5-year CAGR)





Figure 1.3: Hyperinflation episodes over the past century

Country Year(s) High

inflation per month %

Country Year(s) Highest infla-

tion per month %

Argentina 1989/90 196.6 Hungary 1945/46 1.295

Armenia 1993/94 438.04 Kazakhstan 1994 57

Austria 1921/22 124.27 Kyrgyzstan 1992 157

Azerbaijan 1991/94 118.09 Nicaragua 1986/89 126.62

Belarus 1994 53.4 Peru 1988/90 114.14

Bolivia 1984/86 120.39 Poland 1921/24 187.54

Brazil 1989/93 84.32 Poland 1989/90 77.33

Bulgaria 1997 242.7 Serbia 1992/94 309000000

China 1947/49 4208.73 Soviet Union 1922/24 278.72

Congo (Zaire) 1991/94 225 Taiwan 1945/49 398.73

France 1789/96 143.26 Tajikistan 1995 78.1

Georgia 1993/94 196.72 Turkmenistan 1993/96 62.5

Germany 1920/23 29525.71 Ukraine 1992/94 249

Greece 1942/45 11288 Yugoslavia 1990 58.82

Hungary 1923/24 82.18 Zimbabwe 2008/09 6.5 *1021

Source: Bernholz (2003), Wikipedia

As a result, an inflation strategy could largely materialize involun-

tarily. One can argue that unanticipated inflation could still be-

come an issue in the US (and the UK!), in the form of unintended

consequences of current monetary easing. Indeed, it is very likely

current experiments in monetary policies will prove hard to re-

verse, especially in the wake of current over-confidence of policy-

makers. In the case of uncontrolled inflation, gold would have a

great future! The UK is the most vulnerable country for that situ-

ation, where the Bank of England (BoE) could at some point open

the Pandora box of inflation, with its aggressive monetization in a context of declining productivity and current account defi-cits. By mimicking the US, the UK seems to have neglected the fact that it does not have a major reserve currency. With a de-terioration of the currency and the standard of living, its own citizens could themselves be tempted to flee their own cur-rency, without any natural external buyers!




Write-off and spoliation: Déjà vu

Is there truly a clear path to a write-off strategy? When one considers the similarities between the balance sheet of United States of America and General Motors (in 2008) in terms of to-tal debt, unfunded liabilities, persistent need for funding, con-flict of interests and the way creditors were ultimately treated, any foreign holder of US treasury securities should be afraid. Given the past behavior of the US to preserve its own interests above all principles, it is hard to expect this country to play by the rules and comply with its obligations to foreign creditors if this requires any painful sacrifice for its population (and vot-ers!). In his 2004 book, “Colossus, The Price of American Em-pire”, historian Niall Ferguson presents a defining feature of the US: It is not a country like any other. It is an Empire! While powerful abroad, with its unsurpassed military might, the US has the typical Achilles’ heel of any empire: the need for exter-nal financing. The Chinese, Japanese and Europeans have been willing to purchase American Treasury notes and bonds to fi-nance this expensive military hegemony. While he sees infla-tion as the likely exit to dilute debt, and he discards debt default, we see it otherwise. Indeed, we challenge the view that the US will not default because its debt is denominated in its own currency. In fact, the US public sector has defaulted sev-eral times in the past, in one way or another, and clearly at the expenses of some less powerful entities. Since Independence, a default has occurred about every 50 years. And the last time, the US declined to comply with its obligations towards credi-tors was in 1971, just 42 years ago!

A selective US default is on the cards because it is possible, profitable and is consistent with US conduct. The write-off strategy carries many benefits for the US, regardless of the negative impact overseas. Since America became the dominant power of the western world after the two World Wars, it has always played by its own rules. It drafted major world regula-tions, but surprisingly the country has a strong record of not applying them and not ratifying them, especially in the recent past. The US has managed unilaterally its special status, even outside the field of finance and economics. For instance, it sup-ported the International Court of Justice for war criminals, but in the end the institution can try anyone in the world except Americans. The US did not ratify the Anti-Ballistic Missile (ABM) Treaty, the Kyoto protocol on carbon emissions, or the





Ottawa treaty on banning anti-personnel mines. The US agri-culture policy stance was also one of the major causes of the collapse of the World Trade Organization (WTO) Doha round, because America preferred protecting its cotton industry –among others- at the expense of broader agreements on global trade. We see the same behavior on banking, where the US is now deciding to delay the application on Basel III, which makes efforts of Europeans -including the Swiss- useless, when they are pushing hard on their own banks. The issue is that it is well known that large banks are interconnected and that the failure of one can impact many others even in other regions. For other countries, having the US relax the standards on risk and capital requirements is like insulating the roof when someone has left the windows open.

America has defaulted often. Harvard academics Reinhart and

Rogoff (2010)4 show how some countries repeatedly default, while

others do not. Greece had such a record, that recent events should

come as a surprise only to ignorant of history… They consider

only two US government defaults, and two state defaults since In-

dependence. Nevertheless, when using a more accurate and

broader definition of government default that includes any occa-

sion when the US government (Federal or State) did not fulfill its

financial obligation towards its creditors (i.e., when creditors lost

money!), we count seven defaults! The list is provided below, and

includes the liability on which the government defaulted, bonds or

currency.

1779: The continental currency default (Currency)

1790: The Continental bonds default (Bonds)

1841: 9-State defaults (Bonds)

1862: The Greenback default (Currency)

1873: 10-State defaults (Bonds)

1933: The Liberty bond default (Currency)

1971: The gold standard default (Currency)

1979: Debt ceiling default on treasury bills (Bonds)

The US only defaulted twice on its Federal debt, in 1790 (Con-tinental bonds), and in 1979. The latter was quite a non-event,

4 Carmen M. Reinhart & Kenneth S. Rogoff, This Time is Different: Eight-Centuries of Fi-

nancial Folly, Princeton, NJ, Princeton University Press, 2009




as it was mostly a technical default on its Treasury bills pay-ments, delayed by a couple of days. In fact, we consider 1933 and 1971 much more critical defaults than 1979, but they tech-nically affected the currency, not the bond repayment in nom-inal terms. These two cases will help elaborate further as to what could be the roadmap for the next default. From the de-faults listed above, we see that at a Federal level, the US de-faults on its currency more often than on its debt, and that currency defaults do not always mean inflation/hyperinfla-tion.

In 1779 and 1862, the US defaulted on a currency it created to raise financing. Both currencies created for same purpose (military expenditures) ended the same way, they lost their value and in the end were redeemable to the Treasury at a frac-tion of the issued parity, or not at all.

In 1933, the US retracted its commitment to redeem bondhold-ers in gold, or in gold-equivalent. Instead, it devalued its cur-rency by 40% and repaid its bonds exclusively in paper currency. With all due respect to Carmen Reinhart and Ken-neth Rogoff or any other academic citing no external defaults for the US during the Depression, this was a clear default, when any foreign investor at a time of the Gold Standard would take a 40%-haircut! US debt at the time was about USD22 billion (USD360 billion in 2010 terms), representing 37% of GDP. This would amount to USD6000 billion relative to today’s GDP, and a 40%-haircut would be quite a huge figure: USD 2.4 tril-lion!

1971 is the classic case of US unilaterally deciding to forego its obligations, especially towards foreigners that had been fi-nancing its twin deficits for a decade, with the explicit guaran-tee that the US dollar was as good as gold. The “Great Society” programs and the Vietnam War were expensive, public deficits were growing, while the current account deteriorated as rela-tively high inflation led to a loss of competitiveness relative to the Japanese and Germans, whose currencies were not reval-ued. In the end, foreigners simply lost their right to gold, over-night, mostly because they asked for it. At the time, foreigners held about USD85 billion (USD460 billion in 2012 terms or USD1100 billion relative to today’s GDP), which were devalued by about 10-20% depending on the base currency (Swiss and Germans were hit the hardest). More than money, they lost their gold. These USD85 billion worth of holdings should have





given owners a right to 75,000 metric tonnes (MT) in gold, a claim to 86% of total gold available at that time! In orders of magnitude, this would be about USD4 trillion at today’s gold prices (compared to USD690 billion obtained from these USD85 billion placed on money markets) or USD7.5 trillion at today’s share of world gold value. This amount is dramatic compared to the current non-resident holdings of US treasur-ies. The recent US response to German officials’ asking to re-patriate their gold in custody at the Federal Reserve Bank of New York is additional evidence of the US being an abusive custodian. It also provides additional fodder for conspiracy theory addicts! Indeed, if the US needs six to seven years to hand over to Germany its gold reserves, one can see the fasci-nation with the view that: “They do not have it anymore! There is simply no more gold in the vault!”5

This historical analogy makes us believe that if the US needs to be relieved from its debt or at least part of it, the country will go the route it has successfully experimented with in the past, through currency and at the expenses of non-residents. For-eigners are by definition non-voting, which makes them par-ticularly vulnerable.

Today, the US is liable to the tune of USD12.4 trillion in the form of marketable securities to the rest of the world, 70% of which is made of debt, the rest being equities and mutual funds. Non-residents own USD4.8 trillion in federal debt (about a third of federal debt); they also own a substantial chunk of public-sector debt –guaranteed by government (of about USD1 trillion in agency bonds) and about USD3 trillion in corporate debt.

Since current liabilities to foreigners are very significant, the incentive for the Treasury to write-off this debt is obvious. We see a couple of scenario for the US to dismiss its current prom-ise of paying back its creditors:

Simple default: deciding to pay only part of its bonds (e.g., 80-90% on the dollar of each bond issued). This

5 To add to confusion and raise further doubt on US gold position, it is worth noticing

that the US Federal Reserve Board is often credited to own 8,100 tons of gold (USD11billion in the balance sheet valued at USD42/oz.). In fact, the Fed does not own any gold to back its currency; it only owns a claim on gold held by the US Treasury, via ‘gold certificates’. It is the Treasury that owns the eight thousand tons since 1934, and the Federal Reserve’s gold certificates are as good (or as bad!) as Treasury bonds!




would bring significant disruptions especially domes-tically within US banks.

Selective default though a new currency issuance: de-ciding to pay only domestic investors, and creating a different currency to pay foreign creditors. Using the 1971 roadmap, we see similarities between the current USD and 1971 gold reserves, and current US Treasuries with 1971 USD reserves. The case for an international dollar to redeem debt held by non-residents would make sense, in the case of fear of inflation from excess money supply and increasing velocity after successive quantitative easing. To prevent this mass of dollars ac-cumulated outside the US (50% of money supply) com-ing home and thereby inflating prices, such a new currency would not be allowed to be freely tradable do-mestically in the US, or at least it ought to be fully dis-tinct from the original USD. Quite quickly, the value of the international dollar would fall below parity vs. USD. Foreign investors, who thought they had USD when holding US Treasuries, would quickly realize who is supporting the cost of public deleveraging, without any recourse. This would be close to the ‘platinum coin gimmick’6, which drew media attention in 2012. In es-sence, it is also fiat currency to repay debt, with no in-flationary cost, only reputational cost. The similarities with 1971, as highlighted in Figure 1.4, are striking: i) some export-driven countries are once again main-taining a cheap currency thanks to artificial measures (i.e., fixed exchange rates, with ballooning official re-serves); ii) foreign central bank assets are again being custodied at the Fed (gold in 1971, and US treasury bonds, which never left the country, even when Ger-man, Japanese and, more recently, the Chinese bought them!); and iii) the US again cannot deliver on prom-ises if creditors ask to be repaid (or simply if they let their bond expire without rolling them).

6 In the US, only the Federal Reserve has the right to issue currency, at the exception of

the Treasury that has the right to issue commemorative coins in any denomination. The idea for reducing debt was for the US government (Treasury) to repay debt with such a coin issued at the value of 1 trillion. For instance, the treasury would repay the trillions of US government bonds purchased by the Federal Reserve, with 2 or 3 of such coins.





Figure 1.4: Historical comparison of US financial position 1971-2012

Items 1971 2012 Comparison Total debt (private + public sector debt)

150% 350% Worse

External position (% GDP)

Creditor (>0) Debtor (-15%) Worse

Public debt (% GDP)

36% 104% Worse

Amount of foreign claims on US gov-ernment (USD)

USD 85 billion (2012

USD 482 billion)

USD 4.3 trillion Similar

as a % of GDP 8% 27% Worse Gold equivalent (MT)

7561.1 8367.3 Similar

Alternative reserve currency

DEM, JPY, FRF, GBP, CHF

Gold, EUR, JPY, CNY

Similar

Currency-exchange rate dispute

Yes Yes Similar

Current account balance

Deficit (largest in the world)

Deficit (largest in the world)

Similar

Undervalued cur-rencies targeted by the US

DEM, JPY CNY, Asian FX, JPY Similar

US Solvency ratio on liabilities

Over-extended by 1:5 Over-extended by 1:2 (2 years of tax

receipts)

Similar

Main nation credi-tors

European, Japanese Chinese, Japanese Similar

Main type of credi-tors

Official institutions (Central banks)

Official institutions (Central banks)

Similar

Main custodian of final claim

Federal Reserve of New York, Fort Knox

Federal Reserve of New York

Similar

Reserve currency USD/Gold US Treasury bonds/USD

Different

Type of foreign claim to the US government

Currency Treasury bonds Different

Ultimate currency owed to foreigners

Gold USD Different

Ultimate backing of external liabilities

US Gold reserves US tax receipts Different

External investor common belief

USD is the reserve proxy for Gold as it is

'as good as gold'

US Treasuries are the reserve tender of the

USD currency

Similar

Event (historical & possible)

US suspended the con-vertibility of USD to

gold

US Treasury suspends redemption of US

bonds with USD, but pays instead in Inter-

national-Dollar

?

Outcome (historical & possible)

Gold squeeze, with gold gaining 2000% in

10-year

USD squeeze? Any large USD gain would prove unsustainable

after 2-3 years

?

Source: US Treasury, IMF, Federal Reserve, Bloomberg




Punitive taxation. Governments are sovereign on their tax reg-ulation, and thus have complete discretion on the tax treatment of US assets (securities, real estate, etc…) held by foreigners, and very likely on the inheritance tax. The recent Foreign Account Tax Compliance Act (FATCA) regulation is going to make in-creased taxation easier and broader. It is the ideal Trojan horse for the US to gather worldwide information and transform any international financial institutions into US tax collectors.

FATCA, a Trojan horse: Spoliation and expropriation mostly comes from changes in regulation and taxation. In that re-spect, the recent tax regulation introduced by America’s Inter-nal Revenue Services (IRS) regarding foreign accounts of US persons is to be monitored closely by foreign investors. FATCA will increase the amount of information required by the IRS, largely on non-US persons (information on US per-sons were already provided under previous agreements), and will turn any financial institution into an IRS-correspondent. It will be almost impossible for any major financial firm to re-fuse cooperation with the IRS as non-FATCA compliant finan-cial institutions will be almost unable to deal with FATCA-compliant institutions. This framework, once all financial firms are included, will be a fantastic tool for the IRS to moni-tor all beneficial owners of US securities throughout the world, even non-US persons, and to eventually tax them. Non-FATCA compliant institutions could be forced to incur a 30% withholding tax on their assets linked to the US, if they enter into any business with any FATCA-compliant firm. FATCA is seen as targeting the US persons overseas, but this view is misleading. Regulations and enforcements on fiscal treat-ments of US persons are largely quite well in place, FATCA is unnecessary for that purpose. It would be consistent with the level of complexity required by FATCA that it aims at other sources of tax revenues, mostly non-resident holding US as-sets. If not, that would be a very sorry situation, where bu-reaucracy would have generate tremendous hassle; for no one to benefit!

The European path to default

Europe sacrificing its own long-term savings. As opposed to the US, the Eurozone does not have a reserve currency, but it does not have any recurring foreign financing needs (i.e., balanced current account). Its current debt crisis is mostly an





internal imbalance between southern liabilities and northern assets. Basically, it was a case of German pensioners financing Spanish real estate developers that were hoping to sell their newly built beach condos to the same German retirees! In the end, the Germans had no intention to retire en masse on the Costa Brava and the phony scheme went bust! We cannot help but mention another European circular system due to the crash: European soccer! How sweet is it to see a Spanish mega-club, heavily indebted and financed by French, German, and Dutch pensioners, trouncing continental clubs over the last decade! Only Spanish (3), Italian (3), English (3) and Por-tuguese (1) clubs have won the Champion’s league over the last ten years. While correlation is not causality, to the casual observer it seems that financial discipline has clearly not been a winning soccer strategy lately! By inflating the professional player market, highly leveraged Mediterranean and English clubs even downgraded other national championships that did not follow the player arms race, which then fell out of fa-vor and led to a drop in relative TV rights. What an irony that in the end, the same German, French, Dutch and Belgian fans, whose local championships have lost their best players, have suffered as their clubs have lost their titles (Germans, Dutch and French clubs clinched 4 titles in the previous 10 years).These same fans even had to pay to watch Spanish and English matches, and the ultimate irony will be when they will be asked (or forced) to pay to bail out these clubs! No sub-prime crisis and no American banks to blame here, just plain madness made in Europe.

As of today, Portugal, Spain (not to mention Greece) have 90-150% of GDP in public debt, and 90-120% in external po-sition (Assets minus Debt to rest of the world). Figure 1.5 highlights what we call the “European Game of Death,” and Figure 1.6 examines the solvency dynamics. The mere service of this external debt implies that a current account surplus of 2-3% of GDP is needed just to stabilize the external balance. In the meantime, current cost of public debt (at 4-5% from yield on most Bonos auctions) requires an equivalent rate of nominal growth to stabilize the public debt once the primary deficit has been eliminated! One word comes to mind: Impos-sible. It is impossible to stabilize external debt with the high growth required to stabilize the public debt. It is impossible to stabilize public debt with the growth contraction required to achieve a 2-3% current account surplus to balance external




accounts. The Euro currency is a straitjacket, pretty much like the Gold Standard was for the US during the Great Depression. Inflationary monetary measures from the ECB, to benefit the countries in southern Europe, are very unlikely to materialize given political differences. Also, and far from the obvious, monetary channels from the ECB to local countries is impaired (like the Federal Reserve System across US states in the 1930s). No growth strategy will solve the external debt circle. The end-game is clearly to relieve Spain from its external debt that is in the form of government bonds due to other Europe-ans. Such a haircut would be supported mostly by pension fund of northern European countries that have long-term sav-ings in the form of capitalized asset reserves (Second pillar). Such redistribution will be much easier than asking for direct taxpayer contributions to bailout overseas investors. Taking a silent haircut in German, Dutch, Belgian and French pension funds is a much more viable political decision for current lead-ers to solve the debt crisis, especially if the victims will under-stand the trick played on them only when they will become pensioners in 15-25 years (1965-1975 cohorts). European leaders will succeed in a perfect silent robbery. Of course, an exit from the Euro is a possible alternative, which means changing EUR-denominated debt owed to other Europeans, into a local currency. This equates to a monetary default as in the case of the US (mentioned above), with probable conse-quences of an increased rate of inflation, a depreciation, and an ultimate loss for foreigners. There is no need for Spain to bear the high cost of exiting the Euro, when its northern neighbors could save the day. This is highly likely, especially if the Spaniards push hard enough. Spain, Portugal and others highly indebted countries could seek a ‘Greek outcome’; namely, benefiting from a debt restructuring and, a bailout at the expense of European banks, insurance companies, pen-sioners, and even Russian depositors (via their offshore ac-counts in Cyprus, whose banks invested in Greek bonds)!





Figure 1.5: European Game of Death

Source: Eurostat, IMF, Author’s calculations, Data of 31 Dec 2012

Figure 1.6: Solvency Dynamics

Source: Eurostat, IMF, Author’s calculations, Data of 31 Dec 2012

The end of the Japanese experiment

Japan all-in. We doubt if Japan, at this stage of population de-cline (which is already well in place with structural deflationary impact), will really be able to reach any steady structural growth, and/or positive inflation target. In case the current attempts by the government and BOJ fail, it seems inevitable the country will

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converge towards the “write-off strategy” through a smooth de-fault of its debt versus its own people. Given the high level of wealth and the domestically-financed nature of the public debt, Japan will not get into any typical debt crisis (such a balance of payment crisis). Japanese will sell foreign holdings in Asia, Eu-rope or the US before getting into trouble with their own liabili-ties. For instance, we could see the smooth write-off in one of two possible ways: i) turning all fixed-maturity JGB held by the public (including via life insurance) into perpetual bonds; and ii) imposing a 100%-inheritance tax on JGBs. This would maintain the income necessary for pensioners through their life, and erase most existing public debt over the renewal of a generation. For instance, the 1950-55 cohort, the largest in size, will slowly ex-pire starting in 2020. In any case, Japan will be interesting to watch because the country is at the forefront of all structural is-sues faced by other OECD countries, namely the decline of an ad-vanced economy caused by the aging of its population.

How does this relate to gold?

In the wake of this possible outcome, Eurozone and Japanese pensioners should immediately diversify away from their assets that their pensions are invested in (Sovereign bonds), and very likely include gold in the holdings as a default-free asset, espe-cially if they want to secure any inheritance. Indeed, it is amazing to see how inspirational Enron has been to Eurozone pensions system! Enron was broke, but managed to look solvent with ac-counting gimmick that hidden long-term debt and in the mean-time it tapped into its employee pension fund to refinance on-going operations (buying its own stocks and bonds) and stay afloat at the expense of future liabilities, and at the cost of ruin-ing all Enron retirees.

On the other side of the oceans, looking at the US, there are sim-ilarities between US public finances and GM balance sheet as we mentioned in the introduction, therefore for non-US residents gold should come in complement to traditional risk-free assets such as US Treasury bonds for their ability to remain free of counter-party risk and untouched by unilateral sovereign deci-sions that has always hurt foreigners.




2. Valuing gold

Overview

Gold is relatively freely traded in most parts of the world. For four decades now, its price is fully set on financial markets, after years of gold being artificially stuck at USD 35/oz. In 1971, the dissolution of the gold standard brought liberalization of gold prices, and subsequent liberalization of trading made the gold market comparable to the market for marketable securities. Gold gained 1,350% in the 1970s, to eventually reach its all-time high annual average price of $612.56 per troy ounce in 1980. The annual average price for gold then ranged from $318 to $478 through the rest of the 1980s. From 1990 through most of 2000, it ranged from $252 to $385. When adjusted for inflation, current prices at the time were the lowest they had been since the early 1970s as shown in Figure 2.1. Since then, gold ramped up four-fold to reach an absolute all-time-high at USD1922/oz in Sep-tember 2011 and has subsequently declined to approximately USD 1250/oz in November 2013. What forces are behind these changes in trends? How is the gold price being determined, what are the drivers, and are there any valuation metrics for gold? An attempt has been made to answer these questions in this chap-ter.



Figure 2.1: Gold price in nominal and real terms (1900-2013)

Source: Bloomberg, BLS, Author’s calculations, Gold prices as of December 2013

Given the historical, universal, monetary usage that we detail in the last section of the book, Gold can be considered both as a commodity and as a currency. This dual nature should be taken into consideration when assessing its price setting mechanism. Also, given its growing popularity among diversified investors, we will also look at gold as an asset class in a comprehensive val-uation framework.

Analysis of the supply and demand dynamics of the com-modity framework reveals that: i) the long-term price is partly a function of total supply related to long-term min-ing costs; and ii) the total physical demand has no clear impact on prices, except for short-term effects, typically seasonal ones.

In the currency framework, the price of gold −typically quoted in US dollars− depends on i) the inverse value of the US dollar versus other currencies; and ii) the attrac-tiveness of gold as a safe currency versus all other cur-rencies. This framework reveals that interest rates and inflation are the most critical gold price drivers.

The asset class approach shows that relative attractive-ness of gold versus other assets is mainly driven by pes-simism, as opposed to equities, which are driven by optimism of better days ahead. Gold turning points are signaled by trends in the equity risk premium, which is the risky assets opportunity cost, especially since 1971.

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This framework helps us inversely link gold with eco-nomic growth. Unsurprisingly, gold is the preferred asset for investors in aging societies as these societies are past their prime and favor safety and conservation over growth and creative destruction.

As we will see, the gold price is mostly defined as a currency. Perspectives of gold as commodity and gold as an asset class also play an important part in the valuation picture, but remain sec-ondary to the currency perspective.

Indeed, gold transactions of the financial or secondary market dwarf the commodity or primary market, with new supply representing only 2% of the total above ground metal. As a result, its price depends, unlike tradi-tional commodities, more on its value perception than on supply and demand dynamics of the physical market.

Gold remains very popular in financial discussions, but it re-mains largely a secondary asset. The entire stock of above ground gold amounting to about 174,200 metric tons, -i.e. USD 7-8 trillion at current prices- is a relatively small figure as com-pared to other financial assets such as the total global market capitalization of bonds, equities and bank deposits (respectively, USD 100, 55 and 60 trillion). Of this amount, much less is availa-ble for trading in the market. About 60 percent or more is em-bedded in jewelry, dentistry, other industrial applications, and central bank holdings, leaving no more than 16-20 percent of the above ground gold or about 0.5% of the total global stock of liq-uid wealth available for private investment.

Gold as a commodity

Fundamental analysis for gold price determination, from a com-modity perspective, naturally involves the study of supply and demand on the physical market. First, we must assessed the ex-isting stocks because gold being indestructible commodity, it never disappears and its stock is what is primarily exchanged in physical markets. Second, demand can be separated in two keys categories: financial demand (FD) and non-financial demand (NFD). Third, supply is based on: new supply coming from min-ing, existing supply returning to market (i.e., scrap) and existing marketable holdings. To avoid logical pitfalls on causality be-tween prices and quantities, we also study of the price impact of




changes in supply and demand to validate or invalidate the pre-dictive power of demand and/or supply.

Gold stock

The total gold ever extracted is estimated at 174,200 metric tons. Being indestructible, and chemically inert, and having been care-fully preserved, and conserved, nearly all the gold that has been mined in the last five millennia is still above ground, 90 percent of which is more or less locatable, and, in large measure, is either still in use, retrievable or potentially available for use, and can be accounted for. The above ground gold stock represents a cube of 21-meter length, which is the most striking fact to grasp how scarce gold is. Divided by world population, it means that each individual can hold no more than 25 grams or about 4 rings as shown on Figures 2.2 and 2.3.

The 20th century has seen rapid and sustained increases in world gold production as seen on Figures 2.4. The output from old and new gold fields has been augmented by the development in mining methods and equipment and in metallurgical extrac-tion processes, yet future supplies appear quite limited. The USGS estimates world underground resources of gold at about 100,000 metric tons (only 50,000 of which are economic re-serves7). According to these estimates, in 1998, the 50% thresh-old was crossed with more gold being extracted than still in recoverable reserves. This would also mean a 60%-increase from the existing amount and such an increase is typically reached in 30 years. And in the end -say 2050- when this amount has been retrieved, total gold would only amount to a cube of 24-meter length.

By coincidence, gold per capita, has been quite constant through-out history at about 20-25g per person, as population grew about as fast as gold was retrieved, as seen on Figure 2.5. Inter-estingly, this possible end of gold accumulation could almost co-incide with the peak of human population. Indeed, United Nations demographic projections increasingly make mention of fast-declining fertility rates, and lower-bound estimates of pop-ulation see a population decline starting in 2050 (while median scenario expect this for 2100). Of course, both estimates on re-serves and population trends at a 50-year horizon are subject to

7 Economic reserves are defined as reserves that can be currently accessed at a profit

given current gold price and extraction costs.





caution… “Forecasting is hard, especially about the future!” - Yogi Berra.

Figure 2.2: 40 Centuries of gold per capita

Source: Gold Money Foundation, GFMS, US Census Bureau

Figure 2.3: A century of gold per capita

Source: Author’s calculations

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Figure 2.4: A century of production and reserves

Source: Author’s calculations, Gold prices as of 31 Dec 2011

Figure 2.5: Population and gold stock have grown at a similar pace

Source: Gold Money Foundation, US Census Bureau, Author’s calculations

Breakdown of gold demand

Change in demand for gold –especially change in financial de-mand– is often cited by commentators and analysts as a key driver of change in prices. Unfortunately, for investors, we find that physical demand’s impact on prices is temporary and be-yond this short-term effect, it is the demand that is driven by

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prices. Not to the contrary! It is precisely what is seen in histori-cal data over a century in the United States: gold consumption per capita drops when prices rise and increases when prices fall. Interestingly, the per capita gold consumption has remained sta-ble over time at 1 ounce per 40 years, independent of rising pur-chasing power. Therefore, over the long run, population growth has been the main driver of greater gold demand.

Non-financial demand

Non-financial demand (NFD) represents the lion share of cur-rent global demand, with about 76 percent of gold consumed an-nually, but not in gross transactions dominated by financial demand as will be described later. Jewelry is the dominant non-financial demand category; others account for some 15% of the NFD as highlighted in Figure 2.6. The next NFD is related to den-tistry followed by the electronic industry using 250 tons of gold for its conductive properties. Evidence across geographies over a period of time displays similar trends of gold consumption. Gold demand for jewelry had been strong; amounting to 3250 tons in the late 1990s when gold was less expensive, but declined by a third, over the last decade as shown in Figure 2.8 and 2.9, with the increase in the price of gold. Based on this diverging trend, highlighting the inaccuracies of the popular explanation of the gold bull market, that the growing Indian middle class’ appe-tite for gold is driving prices.

Figure 2.6: Breakdown of total non-financial demand per sector in 2012

Source: World Gold Council

Jewellery81%

Electronics13%

Dentistry2%

Others4%

100% =2,336 MT




Jewelry, is negatively affected by high prices, and tends to act as a

price buffer. India is the largest gold jewelry manufacturer and

consumer. It has its own unique cultural, economic and financial

basis. India is also the world's top exporter of jewelry, despite the

fact that gold and gems are often intermediary components of Indian

exports that are not counted as metallic exports but rather are counted

as manufactured goods. India's domestic usage of gold may have

perhaps been a bit overstated as India is nowadays more of a major

jewelry producing platform than a few decades ago, exporting its

jewelry to the US, EU countries, and the Middle East. The majority

of jewelry manufacturing establishments worldwide consist of small

shops and individual artisans. According to the USGS publication,

Gold Fields Mineral Services Ltd. estimated in the early 1990s that

perhaps 2 million goldsmiths were working in India, and 400,000

people employed in the jewelry industry in China.

Figure 2.7: Breakdown of total jewelry demand by country in 2012

Source: World Gold Council

It is the cultural aspects that make India the prime holder of gold and silver jewelry as shown in Figure 2.7. There are reasons other than the clichés of Maharajahs’ jubilees and the mysterious Maharanis’ lust for sophisticated jewels8 Gold and precious arti-cles act as secure store of value for Indians, mostly due to the

8 Maharaja is a king and Maharani is a queen in South East Asia.

India29%

China27%

U.S6%

Turkey4%

Saudi Arabia2%

Rest of world32%

100%= 1,908 MT





absence of a dependable banking system and the lack of trust in its currency, as India has suffered from inflation in excess of 7% per annum, and the strict state control over currency converti-bility.

Most marriages in India have long been organized weddings with economic reciprocity where the bride’s jewels serve as the dowry to ensure her future. The artifacts are traditionally and culturally popular, rather essential for a respectable marriage, as well as a necessity in the rural areas where these ornaments act as secure savings to dig out in times of need. In the absence of bank branches, the omnipresent 'mahajan' or 'banya’, (local money lender and merchant), is ever ready to buy or mortgage these artifacts. Of course, there are cases where many men marry women only for their jewelry and gold ornaments and many young women marry rich old men for gold!

Figure 2.8: Annual jewelry demand (MT)

Source: GFMS, World Gold Council, Bloomberg

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Figure 2.9: World jewelry demand versus real gold price

Source: GFMS, Bloomberg, Author’s calculations, Gold prices as of 31 Dec 2012

Figure 2.10: U.S. per capita gold consumption and gold price

Source: U.S. Geological Survey, US Census, Federal Reserve, Author’s calculations, Gold prices as of 30 April 2013

When prices rise, the NFD declines. This reflects the normal cau-sality of price to demand, in a market where supply is somewhat rigid and consumers are price takers. This is relevant with NFD actors given the fragmentation of the buyers (especially in the jewelry segment). Over the medium to long run (one-year and beyond), there is no evidence that NFD has driven prices; there

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is even evidence that prices managed to rise when NFD declined strongly (Figures 2.9 and 2.10).

Analysts and forecasters would be misled if they explained any durable changes in gold prices with NFD, especially jewelry. By extension, any gold forecast based upon projections of NFD is useless. Rather, industry analysts can consistently forecast jew-elry demand and NFD for gold based on its expected price action.

Short-term effects and seasonal patterns

There is one caveat to the notion that there an absence of NFD impact on gold prices: we do believe NFD can consistently im-pact prices over short-term (1-month), and this has brought some significant seasonal patterns in gold prices. The proposed explanation may be building a thesis on a spurious correlation, but the consistency of the evidence deserves to be considered.

Timings of festivals and religious calendar reveal a seasonal ef-fect on gold consumption and prices. In fact, since 1984, gold performs significantly better in the last four months of the year and in January than in other months as shown in Figure 2.11; September being its best month, registering prices upward of 3 percent, on an average.

Figure 2.11: Seasonal profile of gold performance

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Source: Bloomberg, Author’s calculations, Gold prices as of 31 Dec 2012

September marks the end of Indian monsoon period and Indian agricultural cycle. The harvest having been completed and mon-etized, the peasants and farmers have money on hand, and they start converting their cash into gold, given the lack of sound fi-nancial savings system, especially in rural areas (i.e., inflation, unsecure banking system…). This season also marks various Hindu festivals, Durga, Puja, Saraswati Pooja, Dassehra, and Di-wali, falling in the period from October to December, which could also tends to be an auspicious time for weddings. This end- and turn-of-the-year also coincides with Christmas and New Year celebrations in the Anglo Saxon world as well as the Chinese New Year and leads to an exchange of gifts and presents.

These seasonal occurrences are likely to support the idea that gold prices can be affected by NFD in South Asia on a short term basis (1-3 month) during the last quarter of the year (including January). This end and turn of the year also coincides with Christmas and New Year celebrations and exchange of gifts and presents, as well as with the Chinese New Year. This idea was also tested with the Muslim religious calendar, which would also tend to push up gold demand, resulting in price hike during the festivities at the end of the fasting month (Ramadan) and the re-start of weddings that follows the month of Ramadan. The chang-ing date of Ramadan across the Julian calendar would therefore be a test of whether the previous explanations (i.e., reli-gious/seasonal festivities) were spurious about the “end/turn-of-the-year” effect.

The analysis, highlighted in Figure 2.12, shows that prices do in-crease during the month of Ramadan by about 2 percent. The other months display a merely 0.3% average increase since 1980. For this statistical test, the Muslim lunar calendar of 354 days, rolling over the solar calendar of 365 days, brings the month of Ramadan revolving over all the solar months during the study sample. This “out-of-sample” test strengthens the case for seasonal patterns on physical gold demand and its short-term effect on prices.





Figure 2.12: Monthly returns of gold since 1980 sorted based on Ramadan

Source: Bloomberg, Author’s calculations, Gold prices as of 30 April 2013

Financial Demand

Financial demand (FD) represents only about a quarter of total physical demand, but thanks to its high volatility, it has remained the dominant driver of changes in total demand. FD has been growing and its impact has often been denounced for “jacking up” gold prices. Traditionally, FD was dominated by central bank moves; but recent financial demand has been fueled by inves-tors’ appetite for commodities, and by increasing supply of gold tracker funds (such as exchange traded funds), which often use gold futures and physical backing in their holdings.

Figure 2.13: Breakdown of financial demand in 2012

Source: Bloomberg, World Gold Council

1.0%

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0.5%

Month After Ramadan Ramadan non - Ramadan

Bar and coins81%

ETFs18%

Comex1%

100% =1,525 MT




As shown in Figure 2.13, financial demand consists of trackers funds also known as ETFs; future and derivative instruments backed by gold (exchanged on the COMEX in New York) and other private investments, which include gold bars and coins stored mostly in vaults. The first tracker was launched in 2003 and the demand has rapidly grown to reach almost a quarter of total FD. More details on trackers are provided in the section on “Investment vehicles” in Chapter 3. 'Other investments corre-spond to the holdings of gold bullion and coins by individuals and private sector. Central banks are not included because they were net sellers in 2008, as they have been since 1989, but this could change with emerging central banks building up positions on gold, and could reappear in the financial demand calculations.

The financial demand for gold, as compared to non-financial de-mand, is growing and can be very volatile. Although financial de-mand constitutes only 29% of the total demand, its highly volatile behavior makes it potentially a significant driver of gold prices in the short term.

Financial demand has to take into account the negative impact of hedging from the gold mining industry, whether in futures or in options (which act as financial supply that hits the market before its physical supply). By selling futures or option contracts for de-livery of gold at a future date, producers are able to reduce downside price risks, and in some instances, when the price falls more than anticipated, actually make a profit from the hedging. Also, by hedging several years’ production, producers forego the possible profit to be made should the gold price rise. For this rea-son, several producers in the United States and some other coun-tries have been reluctant to hedge.

Gold trackers currently represent in excess of USD100 billion in capitalization or about 75 million ounces in gold. Exchange traded funds (ETFs) replicating gold have been very popular among retail investors, but also with institutional investors. For instance, John Paulson, the famous hedge fund manager has heavily invested in gold through the GLD tracker. The evolution of global gold tracker funds from 2004-2012 is provided in Fig-ure 2.14





Figure 2.14: Global ETF demand (2004-2012)

Source: Bloomberg, Author’s calculation, Gold prices as of 30 April 2013

Given the recent trends, especially in the private financial de-mand, it is hard to understand the precisely impact financial de-mand will have on prices. Unlike other categories of buyers of physical commodities, investors are buying gold in a rising mar-ket: higher prices usually trigger more buying as a result of the herd or momentum effect. Increases (declines) in trading vol-ume on the gold ETF were seen after price increases (decreases). Therefore, there is no tangible evidence of causality, that finan-cial demand is really behind gold price dynamics, as is often mentioned in media or research analysis. Popular headlines such as: “Investor rush on gold ETF fuels gold bull market” have no em-pirical backing. In the light of available evidence, the causality even appears reverse, but given the lack of a significant sample, we leave this as an open question. It is plausible that an exoge-nous change in financial demand could impact gold prices by cre-ating a scarcity on the physical market thus pushing price up. We consider that such an impact is similar to one on any security, which would remain only temporary and can be classified as a short-term catalyst. Such short-term perturbations, caused by behavioral patterns, have often been found in academic research on equities. We will see in the last part of the book, how investors can take advantage of it.

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NewGold iShares gold trust (COMEX)

ZKB gold (SWX) ETF securities

Julius Baer




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