Understanding Gold: Price, demand, and its relation with the USD

26th September 2021

By Team A-Quant

Contributors: Utkarsh Gupta and Siddhant Agrawal

Those who have been keeping a close watch on the commodities market are aware of the constant fluctuation in gold prices. A significant rise in the prices of gold in India was seen since August 2019, wherein in ten days, the prices rose by about 10%-12%. Post-COVID pandemic and its recovery, in September 2021, Gold prices (MCX) fell 7.6% YoY but were flat QoQ. Gold prices are determined in the international markets just like Forex and other commodities, and these prices are mainly determined in the US markets, from where they are imported to India (39% of gold in FY2019 was imported from Switzerland, followed by the US (8.3%), Ghana, Peru, and others) and several factors play a role in its price determination ranging from the strength of INR against USD to RBI policies, and from simple factors of demand and supply to severe market crises.

First things first, how do we get gold in Indian markets?

The answer is Switzerland. We import gold largely from Switzerland, and then the IBJA (Indian bullion Jewellers association) decides the prices. Gold imports climbed up to the second spot in the list of major import items to cater to the demand of the jewelry industry. It stood at USD 6.8 bn in August’21, 82.5% higher than USD 3.7 bn in August’20, and 60.7% higher than USD 4.2 bn in July’21. Gold is imported and brought into Indian markets through banks, which is then supplied to bullion dealers. The rate fixed is based on customs duty and includes a fee. The Indian Bullion Jewellers Association (IBJA), based in Mumbai, sets a rupee price for the gold that is determined based on the top 10 Biggest dealers of the bullion. (To know more about bullion and bullion banks, visit:https://www.investopedia.com/terms/b/bullion.asp)

How do gold prices rise?

Gold prices are affected by a lot of events in the international as well as Indian markets. The current Coronavirus pandemic and other economic crises tend to have a significant impact on gold prices. Gold has always been seen as a very liquid asset; thus, gold increases in its value by a significant amount after every market crash. And the same can be witnessed in today's market as people are investing more and more in gold, to be assured for their money as there is much less volatility than equity markets. Secondly, when RBI decided to increase its gold reserves and imports large amounts of gold from the USA, this causes both an increase due to increase in demand, and due to increased imports, the need to pay using USD thus leads to the devaluation of the Indian currency, which is another factor for increased prices of gold.

The prices in The US and Federal Reserve of the USA's decisions can also significantly affect the commodity price. The Federal Reserves, at its sixth monetary policy meeting of 2021, which concluded on 22 September 2021, announced that it would reduce the monetary stimulus to the US economy and signaled an earlier than expected interest rate hikes strengthening the US dollar (The dollar index rose to a one month high of 93.53) resulting in a decline of gold price. Suppose we want to look at a bigger picture of why gold has risen. In that case, trade wars, the US- Iran conflict, US-China trade war, nuclear threats, and such international wide-scale events cause many uncertainties in the equity markets at such a time gold strengthens. Worries about the fallout from property developer Evergrande's solvency issues spooked financial markets and lifted the dollar index, which hit a near one-month peak on Monday, 26/9/21. A firmer dollar generally makes bullion more expensive for other currency holders.

What about physical gold/jewelry?

India’s gold demand was down by 35% y/y to 446 tonnes in CY2020 due to the COVID-19 pandemic. The demand for gold jewelry fell by 42% YoY to 316 tonnes. The domestic gold refinery industry has not flourished much. In February 2021, Karnataka Mines and Geology Minister Murugesh R Nirani announced that India’s only gold producer Hutti Gold Mines plans to triple its annual production of the yellow metal to 5,000 kg in 1.5 years.

So, we have been observing a lot of fluctuations since August 2019, and the primary reason for this surge in prices was the heavy buying by the RBI. RBI started buying gold after 5 months. The Reserve Bank of India (RBI) bought 7.5 tonnes of gold in October 2019 to add to its foreign exchange reserves, which swelled to $461 billion, including $28 billion gold. This level of heavy demand by the RBI and gold being a rare earth metal with its limited supply caused an increase in the price of gold in the Indian markets, but the demand for physical gold in terms of jewelry and coins was hitting an all-time low.

Also, USD became extremely strong as compared to the Indian Rupee, going from 68.79 INR on 30 July 2019 it went to 77.01 INR in April of 2020. The INR has generally weakened vis-à-vis the USD over 2015 to July 2021 period. Some of this weakness has been engineered by the RBI. For instance, in 2019, the RBI raised its foreign exchange purchases, bringing India’s USD reserves to record highs. This simply meant one had to pay more rupees to import gold; thus, importing prices went up, and hence the prices in the market were high.

How do gold prices fall?

During an emergency, we tend to buy gold due to the volatility of the equity market. Similarly, in a boom within the economy we invest in commodities because of the simple reason that these equities can give a lot more returns than the traditional; investment of gold falls, and due to the fall in demand, the prices tend to go down. Another reason is when the USD devalues; for e.g., When India tries to become export-oriented, the INR gathers strength against the USD. Thus, we have to pay less for the import of gold, and hence the market pricing goes down. However, one thing to keep in mind is that gold can never be too cheap because of the investor's mindset, as even at a low price, people buy them for jewelry and even for investment purposes (With the hope that it will go up). Another reason is that buying gold futures does not make a person own physical gold. Thus, a lot more futures may be issued than the existing physical gold. Due to this simple concept of excess supply over demand, the physical gold prices tend to decrease.

What's to follow?

Analysts say that investors prefer the safe-haven appeal of the world’s reserve currency (US dollar) against the shelter in the precious metal. This may be a reason for Gold's downfall in earlier 2019, but with Fed's signaling earlier than expected interest rate hikes, USD appreciated. To explain this," as a rule, if USD strengthens, gold tends to become more expensive in other currencies, thus the demand goes down, and when the USD loses its value (as now when interest rates are lowered), the prices will go down in other currencies but high in the US. Thus people will sell gold for USD, thus creating a supply of money and gradually the dollar gain back its strength". Just remember, a Gold vs. USD has not happened since 1929, when people started redeeming paper gold for actual gold, the FED was scared they might run out of gold. Thus, they increased the interest rates and signed the Gold Reserves

Act of 1934, made the USD stronger than gold, and was a new start for the USD. Even though that situation is entirely different from the one we are facing today, we can still learn that The US can do the unthinkable to maintain its global dominance.