Is investing in gold a smart move?

Except for the ritual purchase of gold during Diwali, retail purchase of gold coins in India originates from a fear “in case all hell breaks loose”. In times of prosperity, it also gives a sense of pride to the owner.

Gold, in recent times, has been hawked more like as an asset class for investment. If statistics are to be believed 90 per cent of retail traders actually lose money as they lose clarity on the purpose of investment over time – speculation, investment or security.

However, on a macro scale, gold is a powerful competitive international benchmark and that, if allowed to function in a free market, will determine the value of other currencies, the level of interest rates and the value of government bonds. Gold's performance is usually the opposite to that of currencies and bonds. Hence, to defend currencies and bonds, gold prices have to be fought.

Despite gold’s tremendous price increase over the last decade, the precious metal has not kept up with inflation since its last great rise in 1980. Somehow, no one questions as to why it has not kept up with inflation. The answer is that gold derivatives have created a vast imaginary supply for which delivery has not been sought for, since most investors internationally choose to leave their purchases as deposit with the bullion banks that sell them imaginary gold.

On the other hand, in India, gold coins bought even from an established seller (e.g. banks, PSUs) cannot be sold back. So, if gold as an investment has inherent liquidity loss then what is the rational of buying?

All commodity futures markets have created paper promises of supply that could not be covered by real product and have always been settled in cash. RBI had estimated the ratio of paper gold to real gold at 92 to 1. (RBI Report on Issues Related to Gold Imports and Gold Loan – January 2013, Page 58).

Most commodity markets are for goods that eventually are delivered and consumed to a great extent. Gold is different. For gold is not consumed but rather hoarded, even as most gold purchased in the futures markets is never delivered at all (or in miniscule percentage). This system has produced a disproportionate amount of imaginary, elastic, but undeliverable supply, even as people buy gold precisely because they assume that its supply is not elastic, the supply is limited to total past production plus annual mine production.

At this point, individual traders in India should be cautious. In view of the recent fall in gold prices, cautiousness rather than optimism should be the watchword.

The writer is a commodity commentator