By Julian Murdoch
As we covered yesterday, the nature of demand inthe gold market is in flux. Emerging market consumers, not Western buyers, currently drive the bulk of jewelry and physical bullion purchases. Meanwhile, investors in the U.S. have turned to gold ETFs more as trading vehicles than stores of value. Demand has evolved — even from quarter to quarter.
Marcus Grubb is the managing director of investment for the World Gold Council, where he leads both investment research and product innovation, as well as marketing efforts surrounding gold's role as an asset class. Grubb has more than 20 years' experience in global banking, including expertise in stocks, swaps and derivatives.
After the release of the World Gold Council's quarterly Gold Demand Trends survey, Hard Assets Investor spoke with Grubb to get more details on the particulars of some of the report's more surprising conclusions.
Julian Murdoch (Hard Assets Investor): Traditionally, Indian consumers are among the savviest gold consumers. How is Indian demand holding up? And what does that demand pattern tell us about the long-term viability of gold at these price levels?
Marcus Grubb (Managing Director of Investments, World Gold Council): Well, the context for all this is that 2010 was a great year for gold; tonnage reached a 10-year high at 3,812.2 tonnes. And in dollar value, it was an all-time high for the gold market, at $150 billion.
A key element of that was the growth in demand in India in 2010. In total, India reached 745.7 tonnes of jewelry demand, which was up 13 percent [since 1998's peak]. Within that, you had a very strong fourth quarter, continuing the revival of Indian demand last year from the low reached in 2008. And consumer demand, which is a sum of jewelry and investment demand, was up 66 percent relative to 2009. All in all, a very strong picture for the Indian market.
Remember, that's in the face of a very strong gold price in gold markets in 2010, which, despite a small correction, has pretty much continued in 2011.
The other interesting thing, I think, is if you look at recycling. Obviously because India is the largest market, a considerable amount of total recycling comes in from India. But despite a very high gold price, recycling actually fell 1 percent in 2010. Keep in mind, it's 40 percent of supply. Mine production is constrained and growing only slowly, at around 2 percent last year, so the way you can satisfy demand is through recycled gold.
So that shows you the resiliency of the market, and I think it shows also that Indian gold buyers are positive about the future outlook for gold, which is why they're not selling into the strength.
Murdoch: What price level do you think Indian gold buyers will need before they flip that and start selling? What's it going to take to increase the recycling?
Grubb: I think that's much more difficult to determine, the implicit price floor within the Indian market, and generally within jewelry. There's always an element to which if the price goes higher, that may stimulate more recycling. If the price goes lower, you tend to see buyers come back into the market.
So I'd actually flip the logic of your question the other way around, because in the first part of this year we've seen exactly that happening. You saw a largely futures-led sell-off in gold in January, with some redemptions in the ETFs. Mainly long liquidations and rising net shorts on the COMEX drove the gold price down in January between 5.5 to 6 percent. But that was met by strong buying in India and China, and record premiums in the physical market for bars and for jewelry, generally in China, India and some of the other Asian countries.
So you've seen this East/West divide in the early part of 2011. A lot of that has been Indian buying on the dip in the price. You're not seeing a market that's tempted to recycle. You're seeing a market tempted to buy more, because Western investors have pulled back in January, and the prices come down a bit.
Murdoch: One of the other countries mentioned in the report is China. China, which recently reported substantial inflation, increased its demand for small bars and coins 70 percent year-on-year. So who's driving this demand? Are large investors buying gold as an inflation hedge? Or is it smaller investors, individual consumers, augmenting their jewelry buying? Is this the next big retail movement in investing worldwide?
Grubb: It's a fascinating dynamic driving the Chinese market. Last year is a good example. China and India together constituted 51 percent of total jewelry and investment demand in 2010.
Now, India is still the largest market, but what you have developing in China is effectively a catch-up in demand. It's partly driven by the fact that the Chinese market deregulated more recently. It's also driven by the same dynamics in India in terms of economic growth, wealth creation, urbanization and prosperity. And now, increasingly, you have some fear of inflation pressure.
Last year, we put out a report called "Gold in the Year of the Tiger" about Chinese demand. It highlighted that whilst China was now the largest mine producer in the world by country — it's even bigger than South Africa and the United States — it had turned to being a net importer of gold in 2009. In 2010, it imported even more, and for the first part of this year, the figures are very strong.
What you've got is a market that, despite large and growing mine production, is unable to satisfy demand from its own domestic supply. So it's importing gold. That demand is really coming across the board, but you're seeing it very much in the jewelry segment. Looking at the figures for 2010, in China, the change in jewelry [demand] was up 14 percent.
But investment was extremely strong. Total bar and coin investment was up 88 percent. So the story is also on the investment side. And I think that is being driven by retail and affluent investors.
Murdoch: How does Chinese inflation play into this, though?
Grubb: Even with a rising renminbi against the U.S. dollar, China is still sucking in exchange reserves (including the U.S. dollar) at around $190 billion every quarter. First of all, that causes inflation, because it gets into the money supply domestically within China. Secondly, the People's Bank of China currently is seeking to keep in its reserve portfolio about 1.7 percent in physical gold.
Now that becomes a problem when you're bringing in FX reserves at $190 billion every three months. It means unless you want your percent of gold to form your reserve asset portfolio, you have to buy more gold in order to maintain that share of your reserve asset. The issue, though, is that obviously that buying is not transparent to the market. And we can only really guess at that from the strength of the domestic market, from the premiums on the Shanghai Gold Exchange. But if the Chinese Central Bank seeks to keep 1.7 percent of its reserves in physical gold, it's likely to be a buyer when it is pulling FX reserves in at that rate.
Then you have buying among some of the institutions, although that sector is obviously a lot less developed in China. But it's well known that the sovereign wealth fund, the CIC, has a substantial physical gold position through gold ETFs. Also, the World Gold Council in partnership with the ICBC launched a new product last year — a gold accumulation bank account that now has over 1 million account holders and between 10 and 15 tons of gold. That's close to $500 million of gold, achieved in about a year.
So to some degree here, you're seeing physical gold being sought by institutions in China as well.
Murdoch: Speaking of central banks, the Gold Demand Trends Report showed that in 2010, central banks became a net buyer of gold for the first time in 21 years. Is gold on its way back to being a currency standard?
Grubb: Good question. I think the first key thing to point out is, as you've said, the changing paradigm in the central bank sector. It's a major milestone that, after 21 years, central banks have turned into net buyers of gold. They bought around 87 tons in 2010. Our expectation is that this will only continue; that we would expect 2011 to again show net buying.
We can't put a number on it, but when you dissect that, it basically splits into two parts.
Some central banks are very overweight gold for a range of reasons (including historical membership of the gold standard). They have not sold their gold; some still have 40 percent in physical gold of their total reserves. Over the last 20 to 30 years, they have been net sellers. Now that source of supply has ceased.
Then, on the other hand, you're seeing the surface countries accumulating foreign exchange reserves; these include the smaller countries in Asia and Russia up to India and China, in particular. They've been adding to their gold reserves and net-net purchasing more gold. So we think that dynamic is going to continue and, if anything, strengthen in 2011.
We certainly wouldn't advocate or expect a new gold standard. That's not our view. But there may well be an enhanced role for gold in whatever regulatory and financial architecture eventually emerges from the effects of the credit crunch, the recession and now this anemic recovery we're seeing in Western countries. In the central bank sector, there's possibly a role for gold in an SDR [special drawing rights] world, where you add gold into that currency basket. That's obviously wrapped up with China now being the second-largest economy in the world and the potential for renminbi to be an internationally investable currency.
I think there are also moves afoot in the financial markets among some of the banks and exchanges to admit gold as a form of collateral in stock borrowing and lending transactions, and generally in financial transactions. We feel that's a positive step because it's recognizing gold's role as a relatively low volatility store of value in capital transactions and in borrowing and lending transactions.
Finally, I think you're seeing some of the hedge funds — most notably Paulson & Co. — start to look upon gold as a quasi-currency. They have launched share classes for their funds—which are not commodity funds, they're not gold funds — that are denominated in gold as opposed to U.S. dollars, sterling yen or euros. Those share classes are proving very popular. And certainly in 2010, they did very well for their investors.
So I think there are a number of more subtle ways in which gold is becoming reestablished as a monetary asset, and almost as a currency. But we would not advocate a return to the old- fashioned gold standard.
Murdoch: Gold ETFs are clearly the dominant way that big investors decide to express their desire for a safety play in gold. For example, we just saw recently that George Soros increased his position in gold ETFs, albeit slightly. So do you see this as adding volatility to the gold markets?
Grubb: The short answer is no. Just talking physical funds, then our experience as the organization that started that market, is that these instruments have securitized and made accessible an asset class which was previously inaccessible.
In that sense, we feel they haven't contributed, and they don't contribute, to the volatility of the gold price. To me, what bears that out at the moment is the current trailing volatility of gold. Gold volatility is very low right now. It's down to about its normal long-term average, which is around 12-14 percent, which is no more volatile than a major stock index.
So the evidence I think says that ETFs have not caused greater price volatility. For other precious metals, and now in base metals and other commodities, the evidence is clearly different. You know, the ETF flows and the price of those assets is much more volatile. So we feel gold as an asset class has benefited from the ETFs, that they have opened the asset up to a different type of investor base.
Murdoch: Is there a natural point of elasticity for gold demand? Is there a price level at which demand will slacken, and price out the average investor? Or will demand for gold continue forever?
Grubb: History so far shows that what tends to happen is that as the price rises, the amount of grams or ounces you can afford per units of currency declines. So in China and India, consumers have carried on buying; they've just bought less. The price rise has had some impact on the tonnage purchased per unit.
But overall, the growth in demand has been so strong that net-net you've seen a rise in both tonnage and dollar value. That elasticity is very positive for gold.
But I look at it a bit differently. I don't think it's only about the price elasticity of demand. The real key driver is that gold, for a number of reasons, is in demand. And compared with other commodities and other metals, you have an asset that is in much more constrained supply than many of its peers. Mine production is growing only slowly, even in the face of a very strong gold market, and the average time to get a mine to production from finding the gold can be six to 10 years. Basically, the supply response is very inelastic, and that's not the case in a number of other metals.
So I think it's a combination of those two things that's continuing to drive the upward trend in the market, not just the price elasticity of demand side.
Murdoch: Thank you so much for your time.
Grubb: Thank you.
