The Valuation of Gold and its Relation with COVID-19 Crisis
Gold, the crisis commodity, is considered a safe haven to park funds during times of uncertainty. But why? Why do the people of India look towards gold during times of crisis? A recent example can be the COVID-19 situation. As the panic regarding the pandemic grew, so did the prices of gold. It even blew past the Rs. 55,000 mark in August 2020. It was a classic example of using gold as a means of store value.
We understand that the price of any good depends upon its demand and supply. The same is for the case of Gold. However, it is important to understand why does the demand grow (or fall) in numerous circumstances. The demand for gold depends on many factors and all of them combined affect the overall valuation of gold. Let's understand these factors and how they impact the value of gold.
This comes as a no-brainer. Across the globe, the total quantity of gold mined every year is considerably low compared to its demand. This leads to a higher price for the available supply. Moreover, India is a major consumer of gold, with the 2nd highest consumption of gold around the world. With such high demand and comparably lower supply, the yellow metal is bound to be priced expensively in our country.
2. Traditional Factors
Over the years, Gold has been an integral part of India’s traditions. Our country makes use of gold in religious means, family heirloom, investment, and as a status symbol. In addition, India is also the highest consumer of gold in the form of jewelry, with Indian households sitting on a combined pile of more than 25,000 tonnes of gold, valued at more than Rs. 110 lakh crores! (as of Aug 2020). Indians buy gold more during festive and wedding seasons, and as the demand increases during these times, the price also increases simultaneously.
Gold is a well-known hedge against inflation. This is because the price of gold often moves along the direction of inflation. We understand that inflation causes the price level of all goods to rise in general. When this happens, the value of the domestic currency weakens. This further leads to lower real returns (inflation-adjusted returns). This motivates investors to withdraw their investments and park those funds in gold. Historically, gold has proven to beat inflation by a considerable margin, and hence it acts as a hedging tool against inflation. A one-liner for this would be, As inflation rises, so will the price of gold.
4. Deposit Rates
Interest rates have a negative relation with the price of gold. When the interest rates on deposits fall, they provide lower returns, pushing people to withdraw their investments and look for other options. This leads to a rise in demand for gold as an investment. In an adverse situation, when the interest rates rise, the deposits provide higher returns, which attracts more investors, who sell their gold, and invest the same amount in deposits. Both the investments (gold and fixed deposits) have somewhat similar characteristics, with gold having a liquidity advantage.
5. Import Duty
India relies heavily on imports to satisfy its gold requirements. Statistically, India only contributes one percent to the total annual gold production globally. However, as stated earlier, it is amongst the highest consumer of gold. When such a huge quantity of gold is imported into our country, the trade tariffs paid for importing the yellow metal also impact its price significantly.
6. Currency Fluctuations
Gold is dealt in USD in the international market. With fluctuations in currency rates, the price of gold is also impacted. If the rupee weakens, then more rupees are to be paid to import the same amount of gold and vica versa.
7. Crude Oil Price
As surprising as it may sound, there exists a deep and complex relationship between gold and crude oil prices. Crude Oil is traded in the international market with payments generally made in USD terms, and India is the third-largest importer of crude oil as it imports 81% of the total requirements. When the price of crude oil rises, the dollar strengthens because more rupee is converted into dollars for import requirements. Owing to this, the Foreign Institutional Investors withdraw their investments early to avoid profit reductions from currency fluctuations. This further reduces the value of equity in the domestic market, lowering the returns from equity investments. Finally, people withdraw their equity investments and park those funds in gold, leading to higher demand and price of gold. Here’s the visualization of this phenomenon which explains it better.
Consider this scenario for a FII :
At Rs/$ = 72, Investment made = Rs. 1,00,000
Profits earned = Rs. 12,000
Profits in US $ = 12000/72 = $166.67
Now if Indian Rupee depreciates to 75,
Profits in US $ = 12000/75 = $160
Here, the profit reduces, and in the case where crude oil prices rise simultaneously, the following will be the flow of events.
8. Government Reserves
The central government of the country holds gold in the form of reserves. Any policy-related decision to hold or sell the gold in a higher quantity would impact the price of gold. If the government decides to hold the gold reserves, then the price of the yellow metal would rise owing to the reduction in market supply. On the contrary, if the government decides to sell the reserves, the price would decrease owing to reduced cash flow and increased supply in the market.
9. Market Sentiments
This factor comes into play in almost all investment options. It is possible that the market avoids or carries gold for no rational reason. This happens when people act on rumors or emotions, which eventually leads to the formation of a bubble that is very dangerous for any investment. It is essential to identify the reason for the price rise to avoid such bubbles and safeguard one’s hard-earned money.
Having considered the major factors that impact the price of gold, it is now important to address this question. Why is the price of gold surging in the current situation? To understand this, let's compare the current situation of COVID-19 side by side with the gold prices.
As we can observe, the number of cases and the price of gold show correlation in their yearly graphs. During August 2020, the number of cases and the price of gold was rising continuously and are following a similar trend till now. As the situation started to stabilize, the price of gold started falling. Currently, as the number of cases is breaking records, people are again looking towards gold as a safe haven.
Source: The Times of India
Why did the price of gold surge during COVID-19?
The primary reason was the situation of uncertainty caused by the pandemic, which led people to park their funds in safe assets. Markets had crashed and people weren’t sure of what would be the end of the dip. This led them to trust gold as a safe asset and hence the demand for gold increased, and price followed.
As the lockdown was imposed, the gold mining activities also came to a halt. This reduced the supply of gold in the market. When demand grew and supply reduced, the price of gold surged.
During this period, the rupee depreciated to upwards of Rs. 75 against a dollar. As the domestic currency weakened, more rupees had to be paid to import gold, and hence, its price kept on increasing.
The price of gold was also increasing in the international market owing to the need for a safe asset. This led to higher import cost which eventually increased the price of gold in the domestic country
Gold is considered a hedge against economic and geopolitical crisis and thus, it blasted during the COVID-19 crises.
There even came a period during 2015-2019 when gold was marketed as a dead investment. It is true to some extent. In India, gold is more of an ornament, than an investment. But having understood how the valuation of gold works, now we can conclude that buying gold during crises can generate an exceptional return on investment which is otherwise considered dead.