AURUM – THE GLOWING DAWN!!!

Assignment on:

1. Determination of International Gold prices.

2. Reasons for increase in the prices.

3. Rationale behind the recent Gold purchase by

Government of India.

12/12/2009
Benoy Paul Jose.
BFS.033.
Determination of International Gold
prices
A brief History:

Gold has traditionally been the currency of choice for much of the world’s population. The
value of gold has transcended all national, political, and cultural borders, making it the ideal
currency.

Gold has been used throughout history as a form of payment and has been a relative
standard for currency equivalents specific to economic regions or countries. After World War
II a gold standard was established following the 1944 Bretton Woods conference, fixing the
gold price at US$35 per troy ounce, or, in effect, pricing the U.S. dollar as 1/35th of a troy
ounce of gold.

The system existed until the 1971 Nixon Shock, when the US stopped the direct
convertibility of the United States dollar to gold. Since 1919 the usual benchmark for the
price of gold is known as the London gold fixing, a twice-daily (telephone) meeting of
representatives from five bullion-trading firms. Furthermore, there is active gold trading
based on the intra-day spot price, derived from gold-trading markets around the world as
they open and close throughout the day.

The Gold Fixing, or the London Gold Fixing or Gold Fix, is the procedure by which the price
of gold is set on the London market by the five members of the London Gold Pool. It is
designed to fix a price for settling contracts between members of the London bullion market,
but, informally, the Gold Fixing provides a recognized rate that is used as a benchmark for
pricing the majority of gold products throughout the world’s markets. There are five members
of the Gold Fixing – all of whom are Market Making members of the LBMA. They meet twice
each London business day at 10.30a.m. and 3.00 p.m. at the offices of the Fixing Chairman,
NM Rothschild & Sons Limited. The other four members of the Gold Fixing are the Bank of
Nova Scotia–Scotia Mocatta, Deutsche Bank AG, HSBC Bank USA and Société Générale.

The first fixing took place on September 12, 1919 amongst the five principal gold bullion
traders and refiners of the day. The price of gold then was four pounds 18 shillings and nine
pence per troy ounce. Gold Prices are fixed in United States dollars (USD), Pound sterling
(GBP) and European Euros (EUR).

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In April 2004, N M Rothschild & Sons announced that it planned to withdraw from gold
trading and from the London Gold Fixing. Barclays Bank took its place from 7 June 2004,
and the chairmanship of the meeting, formerly held permanently by Rothschilds, now rotates
annually. On January 21 1980 the Gold Fixing reached the price of $850, a figure which was
not overtaken until December 1, 2009. This is when the prices soared to a new record of
$1200 per troy ounce. However, with inflation, the 1980 high would be equal to a price of
$2398.21 (in 2007 dollars). So, the 1980 record still holds in real terms. While gold is traded
in markets throughout the world, the market is essentially homogeneous since the gold price
is always in dollars and the gold traded is "loco London" (gold deliverable in London and
meeting London trading standards).

The London Bullion Association:

The LBMA is the London-based trade association that represents the wholesale gold and
silver bullion market in London. London is the focus of the international Over-the-Counter
(OTC) market for gold and silver, with a client base that includes the majority of the central
banks that hold gold, plus producers, refiners, fabricators and other traders throughout the
world.
The LBMA was formally incorporated in 1987 in close consultation with the Bank of England,
which was the bullion market’s regulator at that time. The primary regulator for the bullion
market in the UK is now the Financial Services Authority, with which the Association
maintains a close working relationship.

The Process

The price of gold is fixed twice daily in London by the five members of the London gold pool,
all members of the London Bullion Market Association. The fixes start at 10.30 a.m., and
3.00 p.m. London time. Since 1968 the usual benchmark for the price of gold is known as
the London Gold Fixing. The London PM fix is normally considered the main reference price
for the day and is the price most often used in contracts. The price of gold is quoted in USD
per troy ounce. Since May 2004 it has been conducted by telephone. Daily the
representatives from five bullion-trading firms meet (telephone) to fix the rate.

Clients place orders with the dealing rooms of fixing members, who net all orders before
communicating their interest to their representative at the fixing. The metal price is then

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adjusted to reflect whether there are more buyers or sellers at a given price until such time
as supply and demand is seen to be balanced. Throughout the proceedings customers may
change their orders, at which point the fixing member will raise a small flag to visually
convey to the other members that they are changing their order. The price cannot be 'fixed'
whilst a flag is raised. The fixing is an open transparent process that allows customers to be
kept advised of price movements, together with the changes in the level of interest, while the
fixing is in progress such that they may cancel, increase or decrease their interest
dependent upon this information.

Furthermore, there is active gold trading based on the intra-day spot price derived from gold-
trading markets around the world as they open and close throughout the day.
On very rare occasions the price will be fixed when there is disequilibrium, at the discretion
of the chairman of the fix. A tradition of the London Gold Fixing was that participants could
raise a small Union Flag on their desk to pause proceedings. Under the telephone fixing
system, participants can register a pause by saying the word "flag", and the chair ends the
meeting with the phrase "There are no flags, and we’re fixed". Influence on gold price: The
day price of gold is driven by supply and demand. Because most of the gold ever mined still
exists and is potentially able to come on to the market for the right price, unlike most other
commodities, the hoarding and disposal plays a much bigger role in affecting the price. A
total of 161,000 tonnes of gold have been mined in human history, as of 2009.

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Reasons for increase in prices
Factors influencing the gold prices:

Historically gold prices were determined by a combination of political and economical

factors, till a universally acceptable concept of London and American gold price was
institutionalised. An outcome of such initiatives was the Washington Agreement. However, in
the past few years, the major factors impacting the gold prices are:

• The demand – supply imbalance.

• Weak US Dollar.
• Growth in Demand for Jewellery.
• Increase in demand for exchange-traded paper backed products.
• US (Fed) Interest rates.
• Crude Oil prices.
• Currency markets.
• Stock markets.
• Political tensions (wars etc.)

The basic economic rule applies to all the commodities, so does it apply to gold also. Higher
the demand for Gold, the higher is its price. Certain nations hold the metal in high regard and
often use it for major purchases or investments (by purchasing jewellery etc). China and
India are very important consumers where there seems to be a emerging business
population looking to invest in some physical cash assets. Gold, Platinum and Diamonds are
also heavily used in industry.
Gold is typically quoted in Dollars, and if the dollar begins to sink then the value of Gold
tends to increase and vice-versa.

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Fifteen Fundamental Reasons for bullish run of Gold

1. Global Currency Debasement:

The US dollar is fundamentally & technically very weak and should fall dramatically.
However, other countries are very reluctant to see their currencies appreciate and are
resisting the fall of the US dollar. Thus, we are in the early stages of a massive global
currency debasement, which will see tangibles, and most particularly gold, rise significantly
in price.

2. Investment Demand for Gold is Accelerating:

When the investors recognize what is unfolding, they will seek an alternative to paper
currencies and financial assets and this will create an enormous investment demand for
gold. To facilitate this demand, a number of new vehicles like Central Gold Trust and gold
Exchange Traded Funds (Elf's) are being created.

3. Alarming Financial Deterioration in the US:

In the space of two years, the federal government budget surplus has been transformed into
a large deficit, which is expected to persist for a longer period. At the same time, the current
account deficit has reached levels which have aggravated the currency collapse.

4. Negative Real Interest Rates in Reserve Currency (US dollar):

To combat the deteriorating financial conditions in the US, interest rates have been dropped
to rock bottom levels, real interest rates are now negative and, according to statements from
the Fed spokesmen, are expected to remain so for some time. There has been a very strong
historical relationship between negative real interest rates and stronger gold prices.

5. Dramatic Increases in Money Supply in the US and Other Nations:

US is facing a threat of deflation given the unprecedented debt burden at all levels of society
in the US. Fed Governor Ben Bernanke is on record as saying the Fed has a printing press
and will use it to combat deflation if necessary. The US government is frantically pumping in
money into the economy. Other nations are following in the US's footsteps and global money
supply is accelerating. This is very gold friendly.

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 6. Existence of a Huge and Growing Gap between Mine Supply and Traditional
Demand:

Gold mine supply is roughly 2500 tonnes per annum and traditional demand (jewellery,
industrial users, etc.) has exceeded this by a considerable margin for a number of years.
Some of this gap has been filled by recycled scrap but central bank gold has been the
primary source of above-ground supply.

7. Mine Supply is anticipated to Decline in the next Three to Four Years:

Even if traditional demand continues to erode due to ongoing worldwide economic

weakness, the supply demand imbalance is expected to persist due to a decline in mine
supply. Mine supply will contract in the next several years, irrespective of gold prices, due to
a dearth of exploration.

8. Large Short Positions:

To fill the gap between mine supply and demand, central bank gold has been mobilized

primarily through the leasing mechanism, which facilitated producer hedging and financial

speculation. Strong evidence suggests that between 10,000 and 16,000 tonnes (30- 50% of

all central bank gold) is currently in the market. This is owed to the central banks by the

bullion banks, which are the counter party in the transactions.

9. Low Interest Rates Discourage Hedging:

Rates are low and falling. With low rates, there isn't sufficient contango to create higher
prices. Thus there is little incentive to hedge, and gold producers are not only hedging, they
are reducing their existing hedge positions, thus removing gold from the market.

10. Rising Gold Prices and Low Interest Rates Discourage Financial Speculation on the
Short Side:

When gold prices were continuously falling and financial speculators could access central
bank gold at a minimal leasing rate (0.5 - 1% per annum), sell it and reinvest the proceeds in
a high yielding bond or Treasury bill, the trade was viewed as a lay up. Everyone did it and
now there are numerous stale short positions. However, these trades now make no sense

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with a rising gold price and declining interest rates. So the investors barely look for selling
gold, but only to buy it.

11. The Central Banks are nearing an Inflection Point when they will be Reluctant to
Provide more Gold to the Market:

The central banks have supplied too much already via the leasing mechanism. In addition,
Far Eastern central banks that are accumulating enormous quantities of US dollars are
rumoured to be buyers of gold to diversify away from the US dollar.

12. Gold is increasing in Popularity:

Gold is seen in a much more positive light in countries beginning to come to the forefront on
the world scene. Prominent developing countries such as China, India and Russia have
been accumulating gold. In fact, China with its 1.3 billion people recently established a
National Gold Exchange and relaxed control over the asset. Demand in China is expected to
rise sharply and could reach 500 tonnes in the next few years. So is it with India.

13. Gold as Money is Gaining Credence:

Islamic nations are investigating a currency backed by gold (the Gold Dinar), the new
President of Argentina proposed, during his campaign, a gold backed peso as an antidote
for the financial catastrophe which his country has experienced and Russia is talking about a
fully convertible currency with gold backing.

14. Rising Geopolitical Tensions:

The deteriorating conditions in the Middle East, the US occupation of Iraq, the nuclear
ambitions of North Korea and the growing conflict between the US and China due to China's
refusal to allow its currency to appreciate against the US dollar headline the geopolitical
issues, which could explode at anytime. A fearful public has a tendency to gravitate towards
gold.

15. Limited Size of the Total Gold Market Provides Tremendous Leverage:

All the physical gold in existence is worth somewhat more than $1 trillion US dollars while
the value of all the publicly traded gold companies in the world is less than $100 billion US
dollars. When the fundamentals ultimately encourage a strong flow of capital towards gold
and gold equities, the trillions upon trillions worth of paper money could propel both to
unfathomably high levels.

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Why should the US Dollar have so much influence?
The current recession has had an impact on the gold prices, as investors and central bank’s
have started investing in gold and reduce their dollar positions/holdings.
A look back to the historical events which has triggered volatility in the markets and the
economies due to dollar impact, would give us a clear picture as to why the gold prices are
surging at an unusual rate.

• US Dollar was surprisingly stable during the turbulent 1970s, when the world was in
global recession (caused by inflation and OPEC oil shocks). Gold price (average)
during this period – $150 per troy ounce.
• From early 1980s, US Dollar appreciated very strongly (60%) while economy
averaged 2.4% pa growth. Gold price (average) during this period – between $750 &
$300 per troy ounce.
• During 1985–95, US Dollar depreciated (–45%), even though economy averaged
2.8% pa growth. Gold price (average) during this period – was in a range of $300 per
troy ounce, with an high of $450 and low of $280 per troy ounce.
• During 1996–2001, US Dollar strong appreciation (40%) while economy averaged
3.2% pa growth. Gold price (average) during this period – range of $280 - $300 per
troy ounce.
• During 2002–08, US Dollar depreciated (–38%) while economy averaged 2.8% pa
growth. Gold price (average) during this period – from a low of $300 it rallied upto
$950 per troy ounce.
• Since April 2008, US Dollar appreciated by 8% while economy has been in
recession. Gold price (average) during this period – from $950 it has surged to a high
of $1200 per troy ounce.

The 1970’s recession was more due to the oil crisis than the performance of the US
economy. The centre point of the current recession can be attributed to the US. So the dollar
impact on the gold price is more, comparing to the previous scenarios. The above figures
clearly indicate the negative correlation of USD and Gold prices. The current recession has
its roots grown deep into the US economy. The deficits of the US government are on historic
high levels. This has put pressure on the dollar, leading a depreciation of the USD. Thus
making gold dearer.

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Rationale behind Gold purchase by
India

India bought 200 metric tons from the International Monetary Fund, this November, for
$6.7billion as central banks show increased interest in diversifying their holdings to protect
against a slumping dollar. India’s foreign-exchange reserves rose $1.38 billion to $286.7
billion in the week ended Nov. 27. Gold holdings thus increased to 557.7 metric tons after
the central bank bought the metal. The transaction, equivalent to 8 percent of world annual
mine production, was the IMF’s first such sale in nine years and propels India to the ninth-
biggest government owner globally.

Traditionally India was a price taker for gold, even though it is the largest consumer of gold.
The recent buy from IMF have created a new trend. And with this purchase from the IMF,
India has gone from being a price taker as a jewelry consumer to being a price maker as an
investor.

The official explanation to this was that the activity is “as part of its foreign exchange
reserves management operations”.

The fall in the U.S. dollar is the major reason for the central bank to strengthen their portfolio
with gold, as gold is considered a safe store of value compared to the U.S. dollar. By
investing in gold, the government can diversify its foreign-exchange reserves and hold fewer
dollars. As the exchange rates are increasingly becoming volatile, this is more to hedge the
for-ex reserves. There are increasing fear’s of a weak currency market, it’s better to cut
down on currency holdings and diversify into assets like gold, which has upside potential.

Also, with low interest rates, the RBI fear that there will be inflationary pressure at a later
point and this will devalue the INR, so this buy of gold using USD(which was weaker than
what it is now, when they bought the gold) could be to safeguard the INR. This will help if a
scenario arise where the inflationary pressures arise a year from now and the value of the
INR doesn't appreciate.

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India has been termed as the second fastest growing economy after China. A huge amount
of foreign funds are expected to flow into the economy through FII’s, Venture Capitals et al,
as investments. In this context, it is necessary to protect the value of rupee.

It could also be that, the government wanted to reduce the cash supply in the markets as the
economy is showing positive signs of performance. This would help them have a cap on the
inflationary levels too.

There are analysts in the markets who are of the view that RBI is on for a speculation. They
are of the view that RBI will sell a good amount when the prices reach $1200 per troy ounce.
However this view seems to be a speculative one too. The central bank’s measures are to
safeguard the interests of the economy and not to speculate!

Lastly, the RBI has become an interested party to protect the value of gold at over $1,000 an
ounce. This means that RBI has contributed to an asset bubble by buying gold over $1,000.

A similar situation had taken place in 1980, when market men advised people to purchase
gold when it crossed $400, and then $600 and then touched $800. Those who purchased
the gold even at $500-600 haven’t recovered their investments in inflation adjusted USD.

These high prices are peculiar in the face of falling demand. According to the World Gold
Council demand for physical gold in the first three quarters of 2009 was down by 30 percent
compared to 2008. There will be a price correction. What people do not realise is that
gold’s strength is its own enemy. None of the gold gets consumed. It is preserved. Even
gold dust is collected and recycled. Hence, any incremental supply remains in the market
forever. Without demand there is no supply, and lack of supply brings down the price; in turn
killing the investments!!!

Thus the RBI’s purchase of gold can be termed a very risky gamble.

Reference:
www.article-niche.com
www.kitco.com
www.mcxindia.com
www.archimedesfinancial.com.au
www.bloomberg.com
www.moneycontrol.com (forbesindia)
www.en.wikepedia.org

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