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Will gold and share prices stay high? - Mr.AB - 12-28-2010

An article worth reading.............

By Bharat Jhunjhunwala

The price of gold and shares used to move in opposite directions till the reforms of 1991. Prices of shares used to rise when the economy was buoyant. Property prices used to rise in tandem because demand for land and building rose for new business activities. People used to sell their gold and invest in shares. Increase in share prices came along with a decline in the price of gold. Conversely, investors used to sell shares and buy gold when the economy was sluggish. Presently, however, the prices of gold as well as shares are rising simultaneously. This is due to our integration with the world economy coupled with weakness of the United States economy. Previously import of gold into the country was prohibited.

The price of gold was determined mainly by domestic considerations. Rise or fall in the world markets did not influence the domestic prices much just as a person sitting in a closed room is little affected by the storm outside.The same was the situation in regard to share markets. Foreign investment was prohibited. As a result, the limited wealth of Indian investors shifted from gold to shares or vice versa leading to an inverse relationship between their prices. Nowadays, however, imports of gold and inflows of foreign investment in shares are both allowed. Therefore, prices are determined more by global factors than domestic ones.
Some global investors are looking for safe havens. The British pound was considered ‘safe’ before the Second World War. The American dollar took that position after the war. The US dollar served as the global reserve currency. Some South American countries have even adopted the US dollar as their domestic currency. Investors felt that the US dollar will remain strong.

They invested in US property and companies because they did not apprehend a decline in that currency. Investors believed that money invested in US government treasury bonds was safe. The US economy was very large and would be able to withstand any shocks, they felt. Returns from treasury bonds were lower but that was more than compensated by the security offered. These factors led to the sidelining of gold as a ‘safe haven.’ Investment in gold only brought returns from appreciation while investment in the equally secure US treasury bonds got some returns by the way of interest payments. Thus, some European banks and even the International Monetary Fund sold their holding of gold a few years ago and invested in other paying securities.

This strength of the US dollar was based on three factors. One, new technologies were being created in the US at regular intervals. These inventions brought huge returns to that country. Two, the US was a pioneer in identifying and extracting natural resources for commercial use. For example, Texas was the main supplier of oil till the reserves of West Asia were discovered after the First World War. Three, the competition in the open markets made the companies nimble and strong.

The situation has changed dramatically in the last five years or so. Invention of new technologies appears to have reached a plateau. Other countries have moved to exploit their natural resources. Many countries, including the developing ones, for example, have started offshore drilling for oil. The free market economy has been adopted by almost all countries of the world barring a few like North Korea and Cuba. The special strengths of the United States have now spread across the world. The US is no longer the only pioneer. Accordingly, the US dollar is no longer invincible.Things have become worse for the dollar because of the huge borrowing that country has undertaken to sustain its high levels of consumption. The previous chairman of the US Federal Reserve Board Alan Greenspan encouraged the people to borrow at low rates of interest and buy houses.

This led to a housing boom in that country. The money for this lending was borrowed by selling US treasury bonds to foreign investors. The borrowed money has mostly gone into consumption. Few productive assets have been created. It is now becoming difficult for the US to borrow in the global markets. There is a downward pressure on the dollar. Investors are buying gold and silver to protect themselves against a collapse of the dollar. This is the reason behind the recent increase in the prices of precious metals.

The sustainability of these high prices of gold and silver depends on whether another safe haven currency emerges or not. Chances of such an emergence are slim. China suffers from a lack of openness and transparency. Europe has many crises brewing in the backyard as seen in those of Greece, Ireland and Portugal. Russia has broken up. India is beset with political instability and internal insecurity due to rising inequality. Thus, it seems the precious metals will continue to attract investments in the near future at least. The prices of these metals are likely to remain high.

Buoyancy in our share markets is also likely to be sustained. Our companies have been able to upgrade to global standards of management, quality control and technologies. Indian companies are making huge profits because wage rates are low. We have the winning combination of advanced technologies and cheap labour. Profits of our companies are likely to remain upwards in the coming years. This will lead to continued inflow of foreign investment in our share markets.

The basic point is that the weakness of the US economy is leading to heavy purchases of the precious metals and a global surge in their prices. Thus, the prices of gold and shares are likely to remain high for quite some time, say, five years.
The main danger to this happy scenario arises from internal insecurity. India’s growth story will be a sustained one if we are able to bring true relief to the poor people.