No way out

• Gold demand sets new record year after year. Gold mining remains flat.
  
• Fifteen European Central banks announce "gold will remain an important element of global monetary reserves". They also announce that together they will not sell more than 400 tons per year for the next five years and they will not expand their gold leasings and their use of gold futures and options. (www.gold.org/Gra/Pr/CB_comm.htm)
  
• Many gold mining companies announce that they will buyback their hedges and/or deliver into their hedges.
  
• Asian economies have recovered and are growing.
  
• The threat of inflation is serious.
  

Still, Price of gold(POG) is near its twenty year low. Why?

One of the many possible answers is that the derivatives market has become many times bigger than the underlying physical. Gold bars change hands at prices determined not by demand and supply but by the paper (derivatives) markets. The magnitude of abuse of the derivatives in the gold market has brought us to a corner from where we have no way out. If POG rises beyond a certain critical level then the derivatives market will blow up in the face of those who have been manipulating gold during the last more than two decades. If POG remains range-bound or goes lower then sooner or later the physical market will regain its importance as all the known gold reserves would be irretrievably distributed among the hundreds of millions of gold jewelry lovers.

If POG goes up sharply then the derivative market will blow up. Why?

1. Most of the small traders in the derivatives market are black box(technical) traders. They follow a trend with little or no regard to fundamentals. They, almost always, trade a derivative with a stop-loss in mind. They have a conviction that they will be able to get out of their position, or even reverse them, when the trend reverses.
   
   
2. Many option traders follow the Black Scholes model(a mathematical model) where they write options and when the price moves against them they then delta hedge their exposure. Delta hedging short calls means buying the underlying in increasing increments so that when the price reaches the strike price, the short calls are about 50% covered by long-underlying. For the gold market the repercussion is obvious—should the POG rise, a lot of traders with naked short calls will run to delta hedge either by buying futures or by buying physical. In either case a chain reaction would lead to panic in the gold market similar to or worse than the one after the Washington agreement in Sep'99 and after Placer Dome announcement in feb'2000.
   
   
3. A lot of investment gurus are worried about the stock market bubble. US Fed is worried that inflation may get out of control. ECB has begun to raise interest rates due to inflationary concerns. US is running a record trade deficit which may, ultimately, weaken the dollar significantly. If the bubble bursts or $ weakens and POG is rising, then a lot of investors may decide to park their funds in the gold market either as an insurance or because they want to follow a trend. Even if gold does not regain its safe-haven status, still the additional investment demand may be impossible to satiate.
   
   

For these reasons (and for some more), bullion banks, who have been manipulating the gold market for a long time, know that they have to continue flooding the market with paper gold so that POG continues to drift lower or stay where it is. Their only hope is to hold the price from going up and thereby convince more and more people that gold is no longer money. Double or quits is the name of the game. Office of Comptroller of Currency Administrator of National Banks reports bank derivatives every quarter. (www.occ.treas.gov/deriv/deriv.htm). A quick look at the following table shows a significant increase in the total notional amount of off balance sheet exposure to gold derivatives of all maturities of just 3 US commercial banks and trust companies. The figures do not include the exposure of the likes of Goldman Sachs, Merrill Lynch, UBS, CS and other major international players in the bullion market. Generally speaking, it is true that the notional amount is not an amount at risk. Speaking specifically about gold, it is also true that the exposure to a short gold derivative position could be many times more than the notional amount. This becomes apparent when we convert the US$ into tons of gold. At the current POG, US$ 87 billion is equivalent to about 9,800 tons of gold.

Due to lack of similar information from other major international bullion banks, we have no choice but to guess the total notional amount of off balance sheet exposure to gold derivatives of all bullion banks. Assuming that reported exposure is about a third of the total exposure of bullion banks and half of the total exposure is a net short position (which would lose money should POG increase), we arrive at a total short position of about 15,000 tons of gold. Add to this the amount of physical gold leased by the CBs and sold to millions gold-bugs all over the world and we get a figure that is very close to the total amount of physical gold held on the books of all the world's central banks. This means that should the POG rise, the shorts will not be able to honor their commitment even with the help of all the CBs. Mr. Greenspan's comment to the house banking committee "CBs stand ready to lease gold in increasing quantities should the price rise" would then be seriously tested.

In my opinion, by holding the price of gold from going up, the manipulators are only postponing the inevitable. My reasons are as follows:

1. Investment demand for gold during 1999 was only about 15% of the total demand (equivalent to about US$ 4 billion). Compare this to the world's GDP or to the total stock market capitalization and it would be easy to conclude that even if the price continues to languish, there is very little chance of this demand going much lower.
   
   
2. In India and other developing countries, gold jewelry is predominantly bought by middle income group. Most of these consumers are not even aware of the paper markets. For these gold lovers there is nothing like gold for future delivery, leasing, etc. I say with surety that more than 99.9% of the Indians do not know anything about simple call and put options, what to talk of exotic options, swaps, caps, collars, floors, etc. Very few big retailers in India know about Comex futures. Therefore, for the millions of jewelry lovers it is the price of gold and their buying capacity that is of any relevance. In other words, the basic principle of economics applies to the gold jewelry market -- lower price means higher demand. Most of the actual users in the developing world are not even aware that CBs are selling their gold or bullion banks have a vested interest in capping the POG. Simply put—they buy gold if the have the money to pay for it. In other words, if the POG continues to languish then sooner or later most of the gold still lying with the CBs would be gone. The financial system as we know it would then crash. It is this risk that GATA and others have been talking about.
   
   
3. Gold demand in 1999 was 21% above the total for 1998 and was 7% above the 1997 record. (www.gold.org/Gedt/Gdt30/high.htm). This record was despite a slowdown at the beginning of 4th quarter when POG was sharply higher and very volatile. If the POG is not sharply up from the current levels then it is safe to conclude that demand would continue to grow at about the same rate as the average GDP growth rate of developing economies (major buyers of gold jewelry). Gold mining was more or less flat for 1999. It is estimated (an estimate also accepted by most mega-bears) that current demand exceeds supply by at least 1000 tons. Before the Washington agreement, this gap was being filled by CB sales and leasing. Now 15 CBs have agreed to limit their sales and leasing to not more than 400 tons per year and US, IMF, BIS and Japan appear very unlikely to sell (or lease) gold in increasing quantities(Mr. Greenspan may not agree). The demand-supply gap is already large and widening.
   
   

Unfortunately, the financial wizards heading major bullion banks are not aware of the ground reality and the mainstream press is not willing to talk to the actual users. The mainstream press reports after talking to a gold merchant who may have an interest in defending his own position. For this reason alone the bullion banks believe that if they are able to cap the POG long enough then the physical demand would slowdown on its own. Record demand in 1999 when the POG was at its lowest in two decades is a proof that if POG doesn't rise then demand will.

Whether the manipulators like it or not, if POG goes up then the derivative markets will blow up and if the POG languishes at current levels or goes down then the physical market will blow up. Truly there is no way out.

Sunil Madhok
skmoi@emirates.net.ae
United Arab Emirates

4 May 2000

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Also by Sunil Madhok

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