22/07/2015 9:15 AM IST | Updated 15/07/2016 8:25 AM IST

Why The Gold Crash Is A Mirage

NOAH SEELAM via Getty Images
An Indian trader adjusts jewellry displayed during the Hyderabad Jewellery Pearl and Gem Fair (HJF) in Hyderabad on June 5, 2015. Over 150 exhibitors will show diamond and gold jewellery at the HJF fair in the city from June 5-7, 2015. AFPHOTO/ Noah SEELAM (Photo credit should read NOAH SEELAM/AFP/Getty Images)

Gold has plunged to a five-year low. Is the gold story then over, for now? As with everything else in this market, nothing is as it seems.

Whether it is vegetables, iron ore or smart phones, we know prices fall when there is either too much supply or not enough demand. Gold supply has clearly not shot through the roof. And demand for physical gold in India and China, the biggest markets, is nowhere near satiated. What has changed?

The immediate reason for the fall of gold below $1100/ounce is that for last few months, futures traders in New York and Shanghai have been selling a record quantity of gold. If these traders were selling gold that they physically possess, we could legitimately believe that the gold story is over because they wouldn't have an obligation to buy it back. But that is not so.

These traders are selling short or gold "borrowed" from the market. Short positions are closed in futures markets by buying offsetting long contracts. Since they don't have physical gold, to exit these positions, traders will have to "buy" an equal amount of gold. Such "short covering" inevitably leads to a price rally.

"The daily price of gold itself -- for an $18-trillion global market -- has had, until five months ago, only a tenuous connection with actual demand-supply."

Conspiracy theorists allege that the current sell-off is designed to support the dollar by making it appear stronger against traditional rival gold. If so, the gains would be short-lived. In July 2013, American traders had similarly bet prices would fall. But over the next four months, they had to buy 95.3k long contracts to cover their shorts. Gold rose 18% within two months on short covering alone.

The other factor being held responsible for gold's fall is the disappointment with China's long-awaited announcement of its gold reserves, as the figure was only half of what the market expected. In 2009, China had declared that its gold reserves were a little over 1000 tonnes. This figure has now reached 1658 tonnes, a jump of almost 60%. Traders, who were expecting the number to be around 3000 tonnes, saw this as a bearish cue from the world's largest economy.

Again, the reserves number doesn't tell the full story. Many analysts believe this figure declared by the People's Bank of China to be an understatement given the enormous volumes of gold that have been passing through Hong Kong and Shanghai, as well as the large quantity mined and bought domestically. China also buys gold through the State Administration of Foreign Exchange and the China Investment Corporation. Added together, China may well be the second largest holder of gold bullion after the US -- assuming that the US gold reserve figure, which has not been publicly audited in over 60 years, is accurate.

China, though, is hardly alone in trying to mislead the world about its gold reserves. Switzerland, the hub of the international gold trade, did not declare its numbers for 33 years. The IMF allows central banks to not declare their gold loans and swaps transactions.

The daily price of gold itself -- for an $18-trillion global market -- has had, until five months ago, only a tenuous connection with actual demand-supply. London is at the heart of global daily bullion trading, accounting for three-quarters of the business. For almost a century, traders at four banks used to agree by phone twice-daily on the "London Fix" -- the price used across the world to deal and value bullion. Critics had long charged that the fix process was opaque and vulnerable to market abuse. In 2014, Barclays Bank was fined £26m after a trader was found guilty of manipulating the London Fix. Finally, in March 2015, the system was replaced by a digital and more transparent process still based out of London, run by USA's Intercontinental Exchange that allows easier tracking of price submissions and a full audit history.

"What should you make of it as an investor? The answer is simple. Ignore the signal-to-noise ratio in the prices you see and do the simple demand-supply maths yourself."

In India, where the festival buying season is around the corner, consumers and investors continue to have little idea how the benchmark daily price is fixed. Except for the handful of large bullion wholesalers and importers, the majority of jewellers are in the dark.

The price of gold in, say Mumbai, depends on the international price of gold, converted into rupees, plus the customs duty based on the customs tariff value. The googly lies in the Mumbai market premium, which is added to this straightforward equation. In theory, the premium moves in tandem with the day's demand and supply. But in the absence of any publically available data, the process works like the discredited London Fix. A few large dealers decide the daily premium based on sentiment. The process and names of participants remain opaque. Ncdex* has recently begun publishing a daily benchmark gold premium based on prices polled in Ahmedabad to bring greater transparency for customers. But the old practice, replicated in every city and town, won't vanish overnight.

In short, things are rarely what they seem in the gold market. What should you make of it as an investor? The answer is simple. Ignore the signal-to-noise ratio in the prices you see and do the simple demand-supply maths yourself.

* The author works for Ncdex

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