In previous article, we listed options available in order to gain exposure to gold. This article discusses the relationship of gold and currencies and how gold can help investors hedge against the fall in the value of currencies.
All the transactions in the financial systems and capital markets have two fundamental features. Firstly it involves two parties who are willing to and capable of making an exchange of assets, and secondly an exchange value of the assets. At all times, exchange value is measured in currency; hence the value of the currency itself becomes very important in trading and investing. However, currencies do not have any intrinsic value; they are just promises by the Government agreeing to pay a certain amount as printed on the paper money. Hence all the transactions are based on the trust that government will honor its promise. It is the duty of the government and policy makers to ensure the value of currency does not erode or increase drastically due to unwarranted reasons. A decline in currency, when all other things remain same, would lead to decline in the value of the asset. Considering the ongoing crisis in US and Euro countries, it has become difficult to assess the ability and integrity of policy makers in retaining the value of currencies. Hence it is crucial that a part of currency savings is kept in hard assets such as gold.
During 1940s, most of the developed countries adopted gold standard, and their currencies were based on a fixed rate of USD 35 per ounce of gold. All the currency printed by governments in these countries was backed by gold, officially making it storage value of money. However, there is limited amount of gold in the world (171kt at 2011-end) and most of it being already mined; the supply side remains negligible when compared to the demand. At times of high inflation, when the value of currencies drops, the governments were expected to increase their gold reserve in order to maintain the gold standard. This rigidity of gold finally led to abandonment of gold standard and switching to reserve based currency system. By 1980s most of the countries made the transition from gold standard to fiat currency system, causing the economies all over the world to run basically on trust in the Governments, which in turn put its trust in banking systems. Logically, the capital markets shined better than gold during 1980s to 2000, outperforming the gold. However, during the past decade, there has been gradual increase in the failure of government in honoring their debt and also volatility in the markets. The investors who had kept a part of their savings as investment in market were penalized when the market declined post 2008. The investors have become more skeptical of the actions of Central Banks and Governments in the recent years, considering the failure of the system to protect the interest of investors. Slowly, this has led to gradual accumulation of gold by retail investors who found it prudent to have a part of their assets in gold rather than paper currencies. Off late, even Central Banks have started accumulating gold in order to retain the value of their own currencies. Central banks which held ~36 kt in 1979 gradually reduced its holdings to ~30kt by 2000. Post 2008 they have increased their holdings by 4.3% in a span of four years raising the holdings to ~31.5kt. This shows the deepening of the belief in gold as the store of value.
While certainly most economies would not allow the entire fiat system to fail, it is quite necessary to hedge any loss of savings due to in devaluation of currency. Currently only 16% of the money in circulation is backed by gold and amount of gold in the world is more or less fixed. The price of the gold varies mainly with the sentiment of the investors. During 2012, gold fell by 12% and continued to fall in 2013 mainly due to increased optimism in the market. However, unless some action is seen both at US and Euro-zone, optimism is mere speculation and gold could bounce back. At the current low levels, gold looks attractive compared to other asset classes and it is advisable to buy on dips and accumulate gold during 2013. In the case of economic crisis, the holders of gold can be assured that their savings does not erode due to devaluation of currency or due to inflation.
Another school of thought upholds that majority of gold’s demand is speculative demand and would eventually bring the price down to very minimal amount. The demand for gold for industrial purpose is less than 10% and rest 90% pertains to demand for gold as store of value. If and when there is a policy change restricting the holding and exchange of gold, the price of gold could fall drastically, factoring in the 90% fall in demand. While lot of options are available for gaining exposure in the gold, a good financial advisor would help investors better understand the risks associated with each of them. Prudent wealth management strategies would involve a well planned entry into and exit from gold.
Fixed Income Research 