Gold Demand Dynamics
By Julian Murdoch
As we covered yesterday, the nature of demand in the gold market is in flux.Emerging market consumers, not Western buyers, currently drive thebulk of jewelry and physical bullion purchases. Meanwhile, investors inthe U.S. have turned to gold ETFs more as trading vehicles than storesof value. Demand has evolved — even from quarter to quarter.
MarcusGrubb is the managing director of investment for the World GoldCouncil, where he leads both investment research and product innovation,as well as marketing efforts surrounding gold's role as an assetclass. 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 Trendssurvey, Hard Assets Investor spoke with Grubb to get more details onthe 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 Indiandemand holding up? And what does that demand pattern tell us about thelong-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.
Akey element of that was the growth in demand in India in 2010. Intotal, India reached 745.7 tonnes of jewelry demand, which was up 13percent [since 1998's peak]. Within that, you had a very strong fourthquarter, continuing the revival of Indian demand last year from the lowreached in 2008. And consumer demand, which is a sum of jewelry andinvestment demand, was up 66 percent relative to 2009. All in all, avery strong picture for the Indian market.
Remember, that's inthe face of a very strong gold price in gold markets in 2010, which,despite a small correction, has pretty much continued in 2011.
Theother interesting thing, I think, is if you look at recycling.Obviously because India is the largest market, a considerable amount oftotal recycling comes in from India. But despite a very high goldprice, recycling actually fell 1 percent in 2010. Keep inmind, it's 40 percent of supply. Mine production is constrained andgrowing only slowly, at around 2 percent last year, so the way you cansatisfy demand is through recycled gold.
So that shows you theresiliency of the market, and I think it shows also that Indian goldbuyers are positive about the future outlook for gold, which is whythey're not selling into the strength.
Murdoch: Whatprice level do you think Indian gold buyers will need before they flipthat and start selling? What's it going to take to increase therecycling?
Grubb: I think that's muchmore difficult to determine, the implicit price floor within the Indianmarket, and generally within jewelry. There's always an element towhich if the price goes higher, that may stimulate more recycling. Ifthe price goes lower, you tend to see buyers come back into the market.
SoI'd actually flip the logic of your question the other way around,because in the first part of this year we've seen exactly thathappening. You saw a largely futures-led sell-off in gold in January,with some redemptions in the ETFs. Mainly long liquidations and risingnet shorts on the COMEX drove the gold price down in January between5.5 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.
Soyou've seen this East/West divide in the early part of 2011. A lot ofthat has been Indian buying on the dip in the price. You're not seeing amarket that's tempted to recycle. You're seeing a market tempted tobuy 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 forsmall bars and coins 70 percent year-on-year. So who's driving thisdemand? Are large investors buying gold as an inflation hedge? Or is itsmaller investors, individual consumers, augmenting their jewelrybuying? Is this the next big retail movement in investing worldwide?
Grubb:It's a fascinating dynamic driving the Chinese market. Last year is agood example. China and India together constituted 51 percent of totaljewelry and investment demand in 2010.
Now, India is still thelargest market, but what you have developing in China is effectively acatch-up in demand. It's partly driven by the fact that the Chinesemarket deregulated more recently. It's also driven by the same dynamicsin India in terms of economic growth, wealth creation, urbanization andprosperity. And now, increasingly, you have some fear of inflationpressure.
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 — ithad turned to being a net importer of gold in 2009. In 2010, itimported even more, and for the first part of this year, the figures arevery strong.
What you've got is a market that, despite largeand growing mine production, is unable to satisfy demand from its owndomestic supply. So it's importing gold. That demand is really comingacross 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 alsoon the investment side. And I think that is being driven by retail andaffluent investors.
Murdoch: How does Chinese inflation play into this, though?
Grubb:Even with a rising renminbi against the U.S. dollar, China is stillsucking in exchange reserves (including the U.S. dollar) at around $190billion every quarter. First of all, that causes inflation, because itgets into the money supply domestically within China. Secondly, thePeople's Bank of China currently is seeking to keep in its reserveportfolio about 1.7 percent in physical gold.
Now that becomes aproblem when you're bringing in FX reserves at $190 billion every threemonths. It means unless you want your percent of gold to form yourreserve asset portfolio, you have to buy more gold in order to maintainthat share of your reserve asset. The issue, though, is that obviouslythat buying is not transparent to the market. And we can only reallyguess at that from the strength of the domestic market, from thepremiums on the Shanghai Gold Exchange. But if the Chinese Central Bankseeks to keep 1.7 percent of its reserves in physical gold, it's likelyto be a buyer when it is pulling FX reserves in at that rate.
Thenyou have buying among some of the institutions, although that sectoris obviously a lot less developed in China. But it's well known thatthe sovereign wealth fund, the CIC, has a substantial physical goldposition through gold ETFs. Also, the World Gold Council in partnershipwith the ICBC launched a new product last year — a goldaccumulation bank account that now has over 1 million account holdersand between 10 and 15 tons of gold. That's close to $500 million ofgold, 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 thatin 2010, central banks became a net buyer of gold for the first time in21 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'vesaid, the changing paradigm in the central bank sector. It's a majormilestone that, after 21 years, central banks have turned into netbuyers of gold. They bought around 87 tons in 2010. Our expectation isthat this will only continue; that we would expect 2011 to again shownet buying.
We can't put a number on it, but when you dissect that, it basically splits into two parts.
Somecentral banks are very overweight gold for a range of reasons(including historical membership of the gold standard). They have notsold their gold; some still have 40 percent in physical gold of theirtotal reserves. Over the last 20 to 30 years, they have been netsellers. Now that source of supply has ceased.
Then, on the otherhand, you're seeing the surface countries accumulating foreignexchange reserves; these include the smaller countries in Asia andRussia up to India and China, in particular. They've been adding totheir gold reserves and net-net purchasing more gold. So we think thatdynamic is going to continue and, if anything, strengthen in 2011.
Wecertainly wouldn't advocate or expect a new gold standard. That's notour view. But there may well be an enhanced role for gold in whateverregulatory and financial architecture eventually emerges from theeffects of the credit crunch, the recession and now this anemic recoverywe're seeing in Western countries. In the central bank sector, there'spossibly a role for gold in an SDR [special drawing rights] world,where you add gold into that currency basket. That's obviously wrappedup with China now being the second-largest economy in the world and thepotential for renminbi to be an internationally investable currency.
Ithink there are also moves afoot in the financial markets among someof the banks and exchanges to admit gold as a form of collateral instock borrowing and lending transactions, and generally in financialtransactions. We feel that's a positive step because it's recognizinggold's role as a relatively low volatility store of value in capitaltransactions 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 — thatare denominated in gold as opposed to U.S. dollars, sterling yen oreuros. Those share classes are proving very popular. And certainly in2010, they did very well for their investors.
So I think thereare a number of more subtle ways in which gold is becomingreestablished as a monetary asset, and almost as a currency. But wewould not advocate a return to the old- fashioned gold standard.
Murdoch:Gold ETFs are clearly the dominant way that big investors decide toexpress their desire for a safety play in gold. For example, we justsaw recently that George Soros increased his position in gold ETFs,albeit slightly. So do you see this as adding volatility to the goldmarkets?
Grubb: The short answer isno. Just talking physical funds, then our experience as theorganization that started that market, is that these instruments havesecuritized and made accessible an asset class which was previouslyinaccessible.
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 ofgold. Gold volatility is very low right now. It's down to about itsnormal long-term average, which is around 12-14 percent, which is nomore volatile than a major stock index.
So the evidence I thinksays that ETFs have not caused greater price volatility. For otherprecious metals, and now in base metals and other commodities, theevidence is clearly different. You know, the ETF flows and the price ofthose assets is much more volatile. So we feel gold as an asset classhas benefited from the ETFs, that they have opened the asset up to adifferent type of investor base.
Murdoch: Is there anatural point of elasticity for gold demand? Is there a price level atwhich demand will slacken, and price out the average investor? Or willdemand for gold continue forever?
Grubb:History so far shows that what tends to happen is that as the pricerises, the amount of grams or ounces you can afford per units ofcurrency declines. So in China and India, consumers have carried onbuying; they've just bought less. The price rise has had some impact onthe tonnage purchased per unit.
But overall, the growth indemand has been so strong that net-net you've seen a rise in bothtonnage and dollar value. That elasticity is very positive for gold.
ButI look at it a bit differently. I don't think it's only about theprice elasticity of demand. The real key driver is that gold, for anumber of reasons, is in demand. And compared with other commoditiesand other metals, you have an asset that is in much more constrainedsupply 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 toget 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 thecase in a number of other metals.
So I think it's a combinationof those two things that's continuing to drive the upward trend in themarket, not just the price elasticity of demand side.
Murdoch: Thank you so much for your time.
Grubb: Thank you.