It is common knowledge that Central Banks ("CBs") have lent huge quantities of Gold to the market. They have been lending Gold for the last several years when the US$ price of Gold was much higher than what it is today. Some estimates are upwards of 14,000 tonnes of Gold.

Why did the Central banks choose to lend Gold when they could have sold it for dollars? They would have gotten more dollars for their Gold, and earned the dollar interest rate -- Gold lease rate differential. I feel that the Central Banks chose to lease out their Gold in preference to selling it for the following reasons:

1. The CBs believe that they should continue to back their currency with a significant quantity of Gold. They know that Gold is the ultimate store of value.
   
   
2. The duty of the CBs is to regulate the financial markets - and not to make profit in sale-purchase of Gold and/or other precious metals.
   
   
3. They leased out their Gold not because they wanted to earn the lease money, but to provide liquidity to the markets. The purpose of lending was to prevent a squeeze due to short-term increase in demand and/or cornering of the market by big speculators.
   
   

Have the CBs achieved their purpose, or have they got it awfully wrong? I think that they have got it awfully wrong for the following reasons:

1. The continuity with which they lent Gold to the market at low lease rates capped the price of Gold. Lower prices resulted in higher physical demand and lower mining. Demand-supply gap continued to widen and the CBs continued to fill this gap with easy lending. The Bullion Banks, Gold producers and others borrowed Gold from the CBs and sold it in the cash market for dollars. Though the CBs continue to hold the title to their Gold, there is no way the physical Gold can come back to them.
   
   
2. In addition to the already booked interest rate -- lease rate differential, the borrowers of Gold are sitting over huge mark to market profits as the price of Gold is now at 20 year lows. There is only one problem, a very big problem -- if the Central banks want their Gold back, then where will this Gold come from? For these Gold loans to be settled, either the future mining should exceed future demand and/or the CBs must sell their Gold holdings. If the CBs were to sell their Gold now, then what explanation do they have for leasing out their Gold - when they could have sold it and realized a much higher price?
   
   
3. For mining production to exceed demand, the price of Gold must go up significantly. If the price of Gold does go up significantly, then some big bullion Banks may go bankrupt. One big failure would result in chain of defaults. It appears that some CBs now realize this and, therefore, are planning to sell their Gold reserves just to bail out some market players who are short. It is possible that the Bank of England made the controversial decision to sell their Gold reserves in order to protect some bullion Banks. It is also possible that for the same reason some other CBs may be ready to sell their Gold reserves, whenever the price of Gold starts shooting upwards.
   
   
4. It is the duty of the CBs to correct any imbalances in the economy. Their actions in the Gold market during the last several years have created an explosive imbalance. Demand - supply gap is widening as the price is falling. It is possible that at some point in the not too distant future all the metal available for lease and/or sale will be gobbled up by the masses. At that point will begin the mother of all squeezes - and then not even the G-7 would be able to bail out any Bank and/or trader short. It must be borne in mind that CBs can print currency and/or manipulate interest rates, but to bail out somebody short in Gold they will need Gold.
   
   
5. The biggest proof that the CBs have got it all wrong is that they are being forced to sell Gold at 20 year lows and that too, at a time when the physical demand is far in excess of the current mining.
   
   

A lot of analysts feel that Gold has lost its value as a reserve asset. They know that the sentiment among the Gold investors is already bearish. They believe that sooner or later the masses are going to stop buying Gold and Gold jewelry. Are they right? To answer this question we must also project the demand for Gold jewelry assuming that the price of Gold stays near the 20-year lows or goes down further. In order to make an accurate projection we must understand the psyche of the people who buy Gold jewelry. To understand the psyche of the people who buy Gold jewelry we must identify who are these people, what are their education levels, what are their income levels? Since Indians are the biggest consumers of Gold jewelry, therefore, understanding the Indian mentality with regard to Gold is a step in the right direction.

To start with let me estimate the amount of Gold held by Indians in the various income groups. The following table is based only upon my first hand information of the Indian market and, therefore, can at best be called an educated guess. (Any conclusions from this table may only be made with this in mind)

The above has been estimated with the following in mind:

• Total population of India --- 950 million +
  
• GDP --- INR 16 Trillion ($370 billion)
  
• GDP at purchasing power parity --- $ 1 trillion
  
  

Considering the above table and my knowledge of the Indians, I wish to draw the following conclusions:

1. Even individuals in the extremely poor income bracket own a small amount of Gold.
   
   
2. As Indians prosper they will buy more and more Gold. A lady who can barely buy food for herself or for her child may be wearing a 10 gram Gold bangle. At the same time thousands of rich families own more than 50kgs of Gold. It is safe to conclude that as Indians prosper, they will gobble up all the above ground gold supplies many times over.
   
   
3. The average Gold per capita works out to about 35 grams (about 1 oz). Quite a reasonable estimate considering that India has been importing Gold @ 1 gram per capita per year for the last several decades.
   
   
4. It is safe to assume that the poor people in India have not heard of something like short-selling. They do not believe that somebody can sell what he does not own. Most Indians have never heard of "Central Bank selling" or "Gold leasing" or "producers selling their future production."
   
   
5. An Indian would go without food for 2 days, but will not sell his/her Gold jewelry.
   
   
6. India's CB and its lawmakers have been attempting to curb Gold imports - but without success. Prior to 1992, Gold importaation was banned. At that time Gold was smuggled into India in very large quantities - more or less matching the current import rate of more than 700 tonnes per year. Now Gold importation is allowed on payment of about 10% import duty. In order to limit the import of Gold and for utilizing the foreign currency for infrastructure development, India's government has come out with several Gold Bond schemes. The response of the Indian public to these Gold Bond schemes has been extremely poor. Even the uneducated Indians know that Gold in hand is any day better than a piece of government backed paper (Bond).
   
   

From the above it is obvious that Gold demand will surely augment with the increase in prosperity of the developing countries. Furthermore, a lower Gold price and greater money supply will add to demand growth. Lower Gold prices will certainly result in reduced mining. The huge short position in the market, and the widening of demand-supply gap is a dangerous combination. A number of expert analysts feel that whenever the trend reverses, the price of Gold can go up a lot and probably go higher than the all time high of $840. My guess is Gold at more than $1000/oz in the next 5 years.

Sunil Madhok
skmoi@emirates.net.ae

19 August 1999

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Also by Sunil Madhok

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