Impact of Gold in the

Indian Economy




















Members:
Oindrila Roy
Nishant Singh
Vivek S.Nath
Abhijeet Kasliwal
Sinchan Ghosh



2013

MACROECONOMICS PROJECT
A BRIEF HISTORY ON GOLD
India Made Some of the Earliest Coins
Although the world's first coins were Greek coins made in Lydia about 640 BC, is seems clear that India and
China both invented coins independently within a few centuries of the Lydians. The earliest Indian coins were
silver, and it was not until about 100 AD that the Kushan emperor Vima Kadaphises introduced the first Indian
gold coin, which was a gold dinar, bearing the image of Shiva. So India's history of issuing gold coins dates
back almost 2,000 years.

Indians Love Gold
Gold appears to be woven into the very fabric of Indian life. Indian brides traditionally have a dowry of gold.
This is usually in the form of 22 carat or 24 carat gold formed into jewellery, often incorporating gold coins.
Wedding guests also give gold coins as lucky wedding gifts. Perhaps because of a mistrust of banks, the
government or the tax system, many Indians store their wealth in the form of gold bars or gold coins. This
also follows the fact that in spite of rise in price of Gold, the demand has never come down.

Gold and Indian culture
In India, gold is considered much more than a precious metal. For centuries, civilizations have used gold as an
object of luxury. Gold is taken as a sign of supremacy and beauty. It is a sign of power and status. Gold holds
great sacred meaning in Indian culture, as it is the symbol of the Hindu goddess laxmi, considered highly
auspicious. Hindus believe that their goddess was born from the cosmic egg of gold, and hence buying Gold
are inseparable from each other. Many people think that Indians are fanatic of gold. Although this cannot be
entirely denied, but the truth is Gold always had a popular connotations in all ages.
India is a vast country. A combination of several cultures, traditions, customs, religions and regions but
the love for gold is universal. It is equally sought by a rich businessman or a poor farmer. Indians see gold as
a symbol of purity, prosperity and good fortune. Gold purchase in India is related to cultural and religious
beliefs. The Indian tradition demands buying Gold for occasions such as weddings, birthdays, anniversaries
and other important festivals. The hindu calendar also has some auspicious days to buy Gold such as Diwali,
Dhanteras, etc.
In the Indian society, lifes earnings are spent in the big fat weddings and 35-50% of the expenditure
spent for weddings goes in to the purchase of Gold and jewellery. As a custom, the Gold jewellery gifted to
the bride is also displayed in the wedding which symbolizes the status of the family. Gold to us Indians is a
symbol of good luck and a lifetime investment. Like genes and genetic traits, Gold is passed down from
generations to generations. It is considered as an investment and saving which may come to resort during a
huge financial crisis of the family. Even today, though there are many other investment areas like stock
markets, mutual funds, etc. people prefer to invest in Gold.






Indian Gold sources

Source of gold supply from Eastern India, is suggested by certain references in the Mahabharata and equally
vague statement in Periplus. Almost certainly this supply was obtained from the countries beyond Indias
eastern frontier (Burma, the Malay peninsula, Sumatra, etc.) which were significantly known by the titles of
Suvarnadvipa and Suvarnabhumi. Some gold, however, may have been obtained then, as in later ties, from
the river-washings of Chotanagapur Plateau and Assam. In the light of these facts, we may easily explain the
huge imports of the gold coin in the first and the second century A.D., attested alike by contemporary Roman
writers and the surviving specimens, especially those from South India. Gold bullion was exported, according
to the Periplus, from the Persian Gulf by way of Eastern Arabia to Western India.

The huge wealth buried in Indian temples

The story of discovery of treasure [in Sri Padmanabhaswamy Temple] spread like fire around the world,
inviting a universal reaction of awe, mystery and bafflement. What was one to make of the treasure?
Merchants of Tamilakam holds some answers.
Among the treasures found was a vast store of gold coins of the Roman Empire called Aureus as well
as Greek Drachmas; Venetian gold ducats of the fourteenth and fifteenth centuries when Venice was a great
maritime power; Portuguese currency from the days of its glory in the sixteenth century; seventeenth-century
coins of the Dutch East India and eighteenth-century coins of the British East India Company; Napoleon's
gold coins from the early nineteenth century; and much more. It was a veritable feast of India's economic
history. How did the world's bullion end up in the vaults of a temple in south India?
India has always been a maritime, trading nation. With a 5000-mile coastline, it has had a
class of adventurous, seafaring merchants who traded across the seas. The constant flow of precious
metal into India was a part of this trading pattern. Roman senators grumbled that their women used
too many Indian spices and luxuries which drained the Roman Empire of precious metal. Pliny the
Elder, in 77 CE, called India 'the sink of the world's precious metal' in his encyclopaedic work on
classical Rome, Naturalis Historia, in which he describes his voyage from Alexandria across the Indian
Ocean to the famed port of Muziris, near Cochin in south India.
Rome consumed more than she produced and a large part of the drain of gold and silver
which Pliny speaks of went to south India, especially to the east and west coasts of the Deccan. As a
result, rich hoards of Roman coins have been found buried in many coastal Indian sites.
Following Nero's death, the Roman Emperor Vespasian passed a series of laws to curb the
luxurious lifestyle of the upper classes, and luxury imports from India were banned. After that the
Roman trade with India was confined mostly to lower-value commodities such as pepper and
textiles. But the trade imbalance continued and Roman coins moved rapidly in Indian bazaars.
When the Europeans rediscovered India in 1498, they prudently brought silver and gold, acquired
from the mines of their new colonies in America. On returning home from his voyage to India, Vasco
da Gama told King Manuel of Portugal that he had seen 'large cities, large buildings and rivers, and
great populations'. But he added that Indians were not interested in European trinkets and clothes.
Francois Bernier, the French physician to the Mughal emperor
Aurangzeb in the seventeenth century, confirmed the drain in his travel diary: 'It should not
escape notice that gold and silver, after circulating in every other quarter of the globe, come at
length to be absorbed in Hindostan'.
Thus, Indian demand for precious metals continued in exchange particularly for luxury
textilescalico, muslin, chintz, bandanaand these legendary names gradually entered into
European languages. Bernier's compatriot Baron de Montesquieu pretty much summed up the
situation in 1748: 'Every nation that ever traded with the Indians has constantly carried bullion, and
brought merchandises in return . . . They want, therefore, nothing but our bullion.'
This pattern continued till the nineteenth century when the flow reversed suddenly. The
conquest of India by East India Company may have been a factor but the main reason for the
reversal was the Industrial Revolution in Britain. It brought machine-made textiles which rendered
Indian handlooms obsolete. Indians had finally found something they wanted from the West
cheap, durable cottons. Handlooms all over the world gave way to machine-made cloth, [Sanjeev:
this also happened in England, and all handloom producers suffered across the world as it entered
the Industrial Age]. And since India was the world's largest producer of handlooms its weavers
suffered the most. This reverse flow of drain to Britain persisted until textile mills came up in India
and began to satisfy local demand.
To return to Padmanabha's treasure: the vast hoard of foreign gold coins thus came to India
through trade routes, especially to the rich port cities of south India. The historic drain of precious
metal into India and Padmanabha's treasure raise questions that have engaged economists for
decades. Given the one-way flow of gold and silver into India over the centuries, a staggering
amount has accumulated and lies buried or in vaults across the country. The amount estimated to be
above the ground is between 25,000 to 30,000 tonnes, more than twice that of any other country.
Moreover, India continues to be the destination for a quarter to a third of the world's annual gold
flow, according to the World Gold Council.

Historical Usage of Gold
Silver coins were widely used in India during the reign of the Mauryas circa 250 BC. The first gold coins were
issued widely during the Gupta dynasty around 250 AD. Interestingly, this period was also known as the
Golden Age. On the face of it, every emperor issues coins to accentuate the significance of his rule. However,
there was a more practical reason for Indians to use gold as money.
Every once in a while, a ruler such as Emperor Chandragupta Maurya appeared on the scene and was
able to consolidate a majority of India. However, no sooner did such an able emperor pass away than his
empire disintegrated. Gold, being of high value, could easily be hidden during times of strife, enabling
ordinary citizens to avoid being looted by marauding armies. Further, a gold coin issued by one king could
serve as money under any other king as long as the weight and purity of the issued coin could be assessed.
Therefore, gold was the preferred medium of exchange and store of wealth.
The history of dowry in India is almost as old as the Hindu religion itself. Dowry, before the negative
connotations of today, was a gift from the bride's family to a newly married couple. It was to compensate the
groom for the additional expenses he would incur taking care of his stay-at-home bride and eventually their
family. Although different commodities were used to pay dowry, gold was the preferred option simply
because it was easily safeguarded and widely accepted. The practice of giving gold and jewels as dowry
continues to this day. Another offshoot of the rich tradition of gold in the Hindu religion explains why Indians
mark every auspicious and festive occasion with the purchase of a token amount of gold. Parents with
daughters begin accumulating gold in small quantities yearly on these occasions, in anticipation of their
daughters' weddings.
India's disastrous 1962 war with China severely depleted India's foreign reserves and removed the
backing for the rupee. To prevent a massive flight out of the rupee, the government established the Gold
Control Act in 1962, forbidding private ownership of gold bullion and mandating the conversion of all private
gold bullion into gold jewelry. This prevented the rise of an alternate currency if the rupee should flounder. As
with all government intrusions, this law had unintended consequences. Because licenses were required to
hold gold bullion, many goldsmiths not connected to the establishment lost their livelihoods overnight. The
prohibition also gave rise to gold smuggling and a huge black market in gold, which no doubt claimed many
lives and livelihoods.
Further, in 1969, the Indian government under Indira Gandhi nationalized the banks and mandated
licenses for almost everything. This was the beginning of the "License Raj" in India, which instituted rampant
corruption in all levels of the bureaucracy. Since the state controlled all the banks, loans were made to special
sectors just to buy votes.
The 1970s were an even more tumultuous period politically in India. A state of emergency was
declared from 1975 to 1977, giving almost dictatorial powers to Indira Gandhi. When democracy was restored
in 1977, Ms. Gandhi was ousted by Morarji Desai. However, the common man still couldn't catch a break, as
marginal tax rates hit a scarcely believable 95 percent and the rupee's value declined steadily.
In light of these circumstances, gold was the average Indian's best friend. Due to a ban on gold, the
value of gold in relation to other commodities and the rupee soared. The high marginal tax rate gave rise to a
huge black market. Citizens needed a way to hide and protect their assets from the taxman, and gold was one
of the two asset classes that proved effective for doing so (the other being real estate).
One last reason why extensive gold holdings are prudent in today's context is the paltry level of
insurance provided to bank deposits. A fractional reserve banking system is inherently insolvent and needs
government insurance to prevent a run on deposits. In India, the amount covered under deposit insurance is
just Rs100,000. Because of the low level of insurance and the fractional-reserve system, many savvy
consumers hedge by holding a portion of their savings in gold. Moreover, millions of people in rural India
completely bypass the banking system because they don't understand it and prefer to hold their savings in
gold. When in need of money in a crunch, they pledge their gold with a local money lender in return for
currency.
In summation, India's ancient and deep religious traditions, combined with a plethora of historical,
cultural, and practical reasons, have fostered an unflinching desire to acquire gold as a means of protecting
one's wealth. In this light, one can hardly dismiss this desire as irrational. Given what's in store for the world at
large when the inevitable currency crisis occurs, citizens from other countries could do worse than to take a
leaf out of India's history with gold.
Shift from Silver Standard to Gold Standard
Many historians state that India lost its glory and richness due to invasions, foreign culture diluting the
traditions, British rule, territorial disputes among the princely states, etc. While all these were ingredients for
Indians decline, the catalyst for Indias poverty and was the shift from Silver standard to Gold standard. In
India, the currency was Rupee. Silver coins were noted to be used in different forms since Magadha kingdom
and it was formalized during Sher Shah Suris regime of Economic development throughout India. Rupee was
official currency of whole of south and south-east Asia and was also adopted in Middle East (Duabi and Qatar
till 1959). When it was said that India had glorious past and was a rich country, it didnt mean just rich kings
or rulers, India as a whole was rich. Pre-1868-1898 (1898 being the date when India adopted Gold standard),
silver and gold were of equal value, i.e., one silver coin you can get the same amount of gold. But this ratio
sharply declined starting from 1872 till 1898, nearly loosing 1/3rd of its value, i.e., 1 rupee was now 30 paise
along with this gold value increased tremendously. Another factor was India doesnt have gold mines to
generate their gold and push its value.
In early 19th century, the valuation system updates were not that fast as in todays internet era, where
people could have dumped silver much faster to reduce the loses. The strategy of devaluation of silver and
making Gold as standard was devised by Issac Newton. The British had awareness of what impact this change
in currency standard will have on Indian economy, but they still did it to gain control over India. Oscar Wilde
in his play The Importance of being Earnest has a dialogue by Miss Prism to Cecily, Cecily, you will read
your Political Economy in my absence. The chapter on the Fall of the Rupee you may omit. It is somewhat too
sensational. Even these metallic problems have their melodramatic side.
In the paper by Prof.Matthias Morys, University of York and Paper on gold standard and Ottoman
Empire by Dr. Cosun Tuncer , it is evidently pointed out that the Core and Peripheral system in the Classic
gold standard era (1870-1914), where the Core (consisting of British, France, Germany and few other
European countries) exploited the exchange rates, interest rates, discount rates, cover ratio and access to
foreign reserves for their advantage against Peripheral countries (that included India). For example; England,
Germany, France and Netherlands are the only countries whose exchange rate never deprecated more than
1% (i.e. they got more gold for same amount of money every time).

GOLD STANDARD
A commitment by participating countries to fix the prices of their domestic currencies in terms of a
specified amount of gold.
A monetary system in which a country's government allows its currency unit to be freely converted
into fixed amounts of gold and vice versa.

National money and other forms of money (bank deposits and notes) were freely converted into gold at the
fixed price." A county under the gold standard would set a price for gold, say $100 an ounce and would buy
and sell gold at that price. This effectively sets a value for the currency; in our fictional example $1 would be
worth 1/100th of an ounce of gold. Other precious metals could be used to set a monetary standard; silver
standards were common in the 1800s.
A BRIEF HISTORY
During most of the 1800s the United States was had a bimetallic system of money, however it was essentially
on a gold standard as very little silver was traded. A true gold standard came to fruition in 1900 with the
passage of the Gold Standard Act. The gold standard effectively came to an end in 1933 when President
Franklin D. Roosevelt outlawed private gold ownership (except for the purposes of jewelery). The Bretton
Woods System, enacted in 1946 created a system of fixed exchange rates that allowed governments to sell
their gold to the United States treasury at the price of $35/ounce. The Bretton Woods system ended on
August 15, 1971, when President Richard Nixon ended trading of gold at the fixed price of $35/ounce. At that
point for the first time in history, formal links between the major world currencies and real commodities
were severed. The gold standard has not been used in any major economy since that time.


HOW THE GOLD STANDARD WORKED?
The gold standard was a domestic standard regulating the quantity and growth rate of a countrys money
supply. Because new production of gold would add only a small fraction to the accumulated stock, and
because the authorities guaranteed free convertibility of gold into nongold money, the gold standard
ensured that the money supply, and hence the price level, would not vary much. But periodic surges in the
worlds gold stock, such as the gold discoveries in Australia and California around 1850, caused price levels to
be very unstable in the short run.
The gold standard was also an international standard determining the value of a countrys currency in terms
of other countries currencies. Because adherents to the standard maintained a fixed price for gold, rates of
exchange between currencies tied to gold were necessarily fixed. For example, the United States fixed the
price of gold at $20.67 per ounce, and Britain fixed the price at 3 17s. 10 per ounce. Therefore, the
exchange rate between dollars and poundsthe par exchange ratenecessarily equaled $4.867 per
pound. Because exchange rates were fixed, the gold standard caused price levels around the world to move
together. This co-movement occurred mainly through an automatic balance-of-payments adjustment
process called the price-specie-flow mechanism.
The fixed exchange rate also caused both monetary and nonmonetary (real) shocks to be transmitted via
flows of gold and capital between countries. Therefore, a shock in one country affected the domestic money
supply, expenditure, price level, and real income in another country. The California gold discovery in 1848 is
an example of a monetary shock.
For the gold standard to work fully, central banks, where they existed, were supposed to play by the rules of
the game. In other words, they were supposed to raise their discount ratesthe interest rate at which the
central bank lends money to member banksto speed a gold inflow, and to lower their discount rates to
facilitate a gold outflow. Thus, if a country was running a balance-of-payments deficit, the rules of the game
required it to allow a gold outflow until the ratio of its price level to that of its principal trading partners was
restored to the par exchange rate. Although exchange rates in principal countries frequently deviated from
par, governments rarely debased their currencies or otherwise manipulated the gold standard to support
domestic economic activity. Suspension of convertibility in England (1797-1821, 1914-1925) and the United
States (1862-1879) did occur in wartime emergencies. But, as promised, convertibility at the original parity
was resumed after the emergency passed. These resumptions fortified the credibility of the gold standard
rule.
ADVANTAGES
Long-term price stability has been described as the great virtue of the gold standard. The gold standard
limits the power of governments to inflate prices through excessive issuance of paper currency. Under
the gold standard, high levels of inflation are rare, and hyperinflation is nearly impossible as the money
supply can only grow at the rate that the gold supply increases. Economy-wide price increases caused by
ever-increasing amounts of currency chasing a constant supply of goods are rare, as gold supply for
monetary use is limited by the available gold that can be minted into coin. High levels of inflation under a
gold standard are usually seen only when warfare destroys a large part of the economy, reducing the
production of goods, or when a major new source of gold becomes available. In the U.S. one of those
periods of warfare was the Civil War, which destroyed the economy of the South, while the California
Gold Rush made large amounts of gold available for minting.
The stability of the gold standard fosters economic prosperity.
The gold standard provides fixed international exchange rates between those countries that have
adopted it, and thus reduces uncertainty in international trade. Historically, imbalances between price
levels in different countries would be partly or wholly offset by an automatic balance-of-payment
adjustment mechanism called the price specie flow mechanism. Gold used to pay for imports reduces
the money supply of importing nations, causing deflation and a reduction in the general price level for
goods and services, making them more competitive, while the importation of gold by net exporters serves
to increase the money supply, causes inflation and an increase in the general price level, making them
less competitive.
The gold standard acts as a check on government deficit spending as it limits the amount of debt that can
be issued. It also prevents governments from inflating away the real value of their already existing debt
through currency devaluation. A central bank cannot be an unlimited buyer of last resort of government
debt. A central bank could not create unlimited quantities of money at will, as there is a limited supply of
gold.
A gold standard cannot be used for, what economists call, financial repression. Newly printed money can
be used to purchase goods and services, and to discharge debts, at no cost to the printer. This acts as a
mechanism to transfer the wealth of society to those that can print money, from everyone else. Financial
repression is most successful in liquidating debts when accompanied by a steady dose of inflation, and it
can be considered a form of taxation. In 1966 Alan Greenspan wrote Deficit spending is simply a scheme
for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of
property rights. If one grasps this, one has no difficulty in understanding the statists antagonism toward
the gold standard. Financial repression negatively affects economic growth.
The gold standard benefits savers by preventing their savings from being devalued or destroyed through
inflation, and by rewarding them with higher real (inflation adjusted) interest rates. In the US and United
Kingdom, from 1945 to 1980 negative real interest rates have cost lenders an estimated 3-4% of GDP per
year on average.
The gold standard tends to limit credit booms and the resulting boom bust cycle because of the inelastic
supply of money. There is no central bank to print ever increasing amounts of money which act as fuel for
the boom, and overextended banks fail sooner as there is no central bank to bail them out, causing credit
to contract and ending any booms that do occur.

DISADVANTAGES
The total amount of gold that has ever been mined has been estimated at around 142,000 metric tons
and arguments have been made that this amount is too small to serve as a monetary base. The value of
this amount of gold is over 6 trillion dollars while the monetary base of the US, with a roughly 20% share
of the world economy, stands at $2.7 trillion at the end of 2011. Even in the unlikely prospect that all
mined gold could be turned into coin, a return to the gold standard would result in a significant increase
in the current value of gold.
The unequal distribution of gold as a natural resource makes the gold standard much more advantageous
in terms of cost and international economic empowerment for those countries that produce gold. In
2010 the largest producers of gold, in order, are China, followed by Australia, the US, South Africa and
Russia. The country with the largest reserves is Australia.
Although the gold standard has brought long-run price stability, it has also historically been associated
with high short-run price volatility. It has been argued by, among others, Anna Schwartz that this kind of
instability in short-term price levels can lead to financial instability as lenders and borrowers become
uncertain about the value of debt.
Deflation punishes debtors. Real debt burdens therefore rise, causing borrowers to cut spending to
service their debts or to default. Lenders become wealthier, but may choose to save some of their
additional wealth rather than spending it all. The overall amount of expenditure is therefore likely to fall.
Mainstream economists believe that economic recessions can be largely mitigated by increasing money
supply during economic downturns. Following a gold standard would mean that the amount of money
would be determined by the supply of gold, and hence monetary policy could no longer be used to
stabilize the economy in times of economic recession. Such reason is often employed to partially blame
the gold standard for the Great Depression, citing that the Federal Reserve couldnt expand credit enough
to offset the deflationary forces at work in the market.
Monetary policy would essentially be determined by the rate of gold production. Fluctuations in the
amount of gold that is mined could cause inflation if there is an increase or deflation if there is a
decrease. Some hold the view that this contributed to the severity and length of the Great Depression as
the gold standard forced the central banks to keep monetary policy too tight, creating deflation.
James Hamilton contended that the gold standard may be susceptible to speculative attacks when a
governments financial position appears weak, although others contend that this very threat discourages
governments engaging in risky policy. For example, some believe that the United States was forced to
contract the money supply and raise interest rates in September 1931 to defend the dollar after
speculators forced Great Britain off the gold standard.
If a country wanted to devalue its currency, a gold standard would generally produce sharper changes
than the smooth declines seen in fiat currencies, depending on the method of devaluation.
Most economists favor a low, positive rate of inflation. Partly this reflects fear of deflationary shocks, but
primarily because they believe that central banks still have some role to play in dampening fluctuations in
output and unemployment. Central banks can more safely play that role when a positive rate of inflation
gives them room to tighten money growth without inducing price declines.
It is difficult to manipulate a gold standard to tailor to an economys demand for money, providing
practical constraints against the measures that central banks might otherwise use to respond to economic
crises. The demand for money always equals the supply of money. Creation of new money reduces
interest rates and thereby increases demand for new lower cost debt, raising the demand for money.

WHAT DO WE USE TODAY?
Almost every country, including the United States, is on a system of fiat money, which the glossary defines as
"money that is intrinsically useless; is used only as a medium of exchange". We saw in the article "Why Does
Money Have Value" that the value of money is set by the supply and demand for money and the supply and
demand for other goods and services in the economy. The prices for those goods and services, including gold
and silver, are allowed to fluctuate based on market forces. Next we'll look at how the monetary system
used can change other variables in the economy.
Although the last vestiges of the gold standard disappeared in 1971, its appeal is still strong. Those who
oppose giving discretionary powers to the central bank are attracted by the simplicity of its basic rule. Others
view it as an effective anchor for the world price level. Still others look back longingly to the fixity of
exchange rates. Despite its appeal, however, many of the conditions that made the gold standard so
successful vanished in 1914. In particular, the importance that governments attach to full employment
means that they are unlikely to make maintaining the gold standard link and its corollary, long-run price
stability, the primary goal of economic policy.

PRICING STRATEGY
DETERMINANTS OF THE PRICE OF GOLD

1) The distinctive properties of gold

Gold has been used as a store of value and form of currency since ancient times. Since the seventeenth
century it has been formally traded over the counter in London and by the nineteenth century it underpinned
the largest fixed exchange rate system the world has ever known (the Gold Standard). In the twentieth
century it was again used as the backbone to a formal exchange rate mechanism (Bretton Woods) but the
collapse of the system in the early 1970s left the price to float freely for the first time in over 250 years.
Golds historical popularity as a currency and a store of value has sprung in part from a number of peculiar
properties not fully shared with competing assets. In contrast to other commodities, gold does not perish or
degrade over time, giving it unique properties as a very long-term store of value. Gold mined today is
interchangeable with gold mined many hundreds of years ago.
The supply of gold has also been relatively fixed for the last century, with annual mine production a small
share of the total stock of gold outstanding and with a limited ability for annual production to rise in
response to changes in the gold price. This marks it out from other commodities where substantial supply
responses to price changes are possible, at least over the medium term.
Another important attribute of gold is its relatively less prominent use for industrial purposes, compared to
other commodities including precious metals such as silver and platinum. Only around 10% of gold demand
in 2010 came from such industrial uses2 with the balance coming from jewellery and investment demand. As
a result, gold prices lack the strong link to the economic cycle that other commodities have and gold has thus
often exhibited low or even negative correlations with these and other financial assets.3
Gold is also unusual among financial assets in not delivering a yield, e.g. a dividend or coupon as paid by
equities and bonds and this can be seen a disincentive to hold gold; however, gold has a significant
advantage compared to some other financial assets which is its lack of default risk.
These factors give gold an unusual set of behavioural characteristics compared to other financial assets.

2) Gold and the general price level
Despite the many different institutional settings (such as the Gold Standard, the Bretton Woods system and
from 1971 a free floating price for gold) and the migration of gold from use as an everyday currency to an
investment vehicle, the long run purchasing power of gold has remained remarkably stable over time.4
In the1830s the price of gold in 2010 dollars was around US$450 per troy ounce, with the real terms price
much the same in 2005, more than a century and a half later.
The tendency for gold to hold its real terms value over long periods has often led to gold being described as
an inflation hedge. However, the reality is more complex as the gold price does not simply move in line
with the general price level but rather exhibits long periods where it moves without any apparent link to
inflation trends.





Currently, the gold price stands well above its post-1971 real terms average but recent history cautions us
against assuming a rapid reversal in the price. The early 1980s experience shows that gold could yet peak
significantly higher than current levels. Moreover, gold prices were above their post-1971 real terms average
for almost all the 1978-1990 period, while in the current bull market prices have only been clearly above this
level since 2007.
It is also possible that while golds real price eventually falls back this takes place not by a fall in the nominal
gold price but by a substantial rise in the general price level, that is that the current price proves an accurate
warning of high inflation down the road.
The strong performance of gold during the inflationary 1970s and early 1980s confirms its potential value in
periods of rapid price rises. Less clear, however, is how gold might fare in a period of prolonged price
deflation. This is because periods of general price deflation are rare. In the last 150 years, the only examples
are the Great Depression of the 1930s and the nineteenth century Great Moderation. Moreover, the gold
price was fixed for the majority of both periods due to the operation of the Gold Standard.
Examination of the behaviour of other commodity prices suggests that had gold been freely floating, its price
would probably have declined during both periods. From 1872-1896 the US wholesale price index (WPI) fell
by 50%, silver prices fell by 54% and copper by 69%. In 1929-1933 the US WPI fell by 31%, silver by 10% and
copper by 60%.
However, this approach fails to take into account that gold is also demanded as a store of value especially
in periods of economic and political turmoil while other commodities are influenced much more by
industrial demand. It is likely that in the early 1930s a period of severe economic dislocation and high
political tensions gold would have outperformed other commodities had it been freely floating.

The examination of these two periods of price deflation also shows that deflation periods can be sharply
different in character. The nineteenth century Great Moderation was a period of economic expansion where
price falls resulted from structural factors such as falling transport costs, which deflated the cost of key
staples. By contrast, the Depression saw deflation resulting from the combination of a financial shock and a
botched policy response leading to a sharp contraction in the money supply and a massive decline in world
output. The behaviour of gold might be expected to vary significantly depending on the causes of deflation.
This highlights the potential importance of the variety of other factors that can have a major impact on the
price of gold in the short and medium-run, which we survey below:



3) Gold and real interest rates

Another factor that can influence gold prices, and to some extent is related to inflation, is the level of real
interest rates. As gold lacks a yield of its own, the opportunity cost of holding gold increases with a real
interest rate increase and decreases with a fall in real interest rates.
Periods of negative real interest rates ought to be especially positive for gold, and this contention is
supported by studying the 1970s when real interest rates were substantially negative for lengthy periods.
More recently, short-term rates near zero combined with modest inflation (and inflation expectations) have
also implied mildly negative real rates and may have supported the demand for gold.
By contrast, the early 1980s saw substantially positive real rates as a result of a concerted attempt by global
central banks to squeeze out inflationary pressures. It is probably no coincidence that in the wake of radical
rate hikes by central banks in this period, gold declined from its 1980 peak level with some funds diverted
into other assets like cash and government bonds.

4) Gold and the US dollar

Since the move to floating exchange rates in the early 1970s, the external value of the US dollar has been a
significant influence on short-term gold price movements. This relationship has been observed by, among
others, Capie et al. (2005)5 and the International Monetary Fund (IMF). The IMF estimated6 in 2008 that 40-
50% of the moves in the gold price since 2002 were dollar-related, with a 1% change in the effective external
value of the dollar leading to a more than 1% change in the gold price.
This relationship exists because:
A falling dollar increases the purchasing power of non-dollar area countries (and a rising dollar reduces it)
driving up prices of commodities including gold (or driving them down in case of a stronger dollar)
In periods of dollar weakness, investors look for an alternative store of value, driving up gold prices. This
includes dollar-based investors concerned about possible inflationary consequences of a weak dollar. In
strong dollar periods the dollar itself is often seen as an appropriate store of value.
Recent history confirms the close association of the gold price with the value of the US dollar. The weakness
of the dollar in the late 1970s was associated with rising gold prices, as was substantial dollar weakening that
began in 2002. By contrast, the strong dollar of the mid-1980s and late 1990s was associated with relatively
low gold prices.




5) Gold and financial stress

A significant and commonly observed influence on the short-term price of gold is the level of financial stress,
which has led to gold sometimes being described as a crisis hedge. In periods of financial stress gold
demand may rise for a number of reasons:
Steep declines in the value of other assets such as equities and high volatility of asset prices, leading to
demand for a more stable store of value uncorrelated with other assets
Fears about the security of other assets such as bonds due to the possibility of default, and even fears about
cash if the health of the banking system is in question the fear of systemic collapse
The need for liquidity in an environment where it may be difficult to realise the value (or the full value) of
other assets.



The link between gold prices and these factors can be seen from an examination of gold and financial stress
measures in recent decades. A well-known indicator of stress and investor risk aversion is the so-called Ted
spread, the spread between the 3-month US interbank rate and the 3-month T-Bill rate. This correlates
especially well with gold prices in the 1970s when massive spikes in the Ted spread were associated with
sharp rises in gold. The Ted spread also rose sharply in the early 1980s; in 1987 in the wake of the stock
market crash and during the global financial crisis of 2007-2009 both also periods of stronger gold prices.
Another common measure of stress is the spread between yields on low grade corporate bonds and
highlyrated bonds (e.g. the BBB-AAA spread). This also correlates quite well with gold prices in the 1970s and
in the first part of the recent financial crisis. Notably, however, the correlation in 2002-2003, when the spread
widened sharply, is less strong and gold has also remained high even though the BBB-AAA spread has
narrowed sharply over the last 18 months.





Golds correlation with another alternative stress measure, VIX equity volatility, is perhaps looser. Notably, the
steep rises in VIX volatility in the late 1990s (connected with the Russian and Brazilian crises) were not
associated with sharp rises in gold indeed gold prices fell during much of this period.
The uncharacteristic behaviour of gold in this period can be seen clearly by examining golds performance in
stressful periods in different decades. In years of elevated stress (when key indicators such as credit spreads,
equity volatility and the Ted spread rose sharply) real gold prices rose an average 33% per annum in the
1970s, 18% per annum in 1980s and 16% per annum in the 2000s all much higher than the average annual
growth rate from 1971-2010



But the 1990s saw real prices fall 10% per annum during crisis years. There appears to be two possible
reasons for this. Firstly, that gold went out of fashion as an asset of choice in risky periods, being superseded
to some extent by cash and government bonds. A long period of relative macroeconomic stability and low
inflation may have reinforced investor perceptions of the safety of cash and government debt, raising their
attractiveness relative to gold for risk-averse investors. Significantly, the dollar was generally strong in the
1990s and tended to gain further during stressful periods which might have contributed to the lack of
correlation between gold and rising financial stress in these years.

Secondly, other factors may have been at work which pushed down the gold price a development that may
have reinforced the unattractiveness of gold to investors. The most likely factors of this kind were central
bank gold sales (see below) and forward hedging by mining firms.
More recently, it is notable that gold has held up well despite a considerable easing of most financial stress
measures towards more normal levels. This once again suggests other factors are in play. A possible factor
that has not been picked up by the standard stress measures is the eurozone sovereign debt crisis, which has
featured government bond spreads in peripheral countries such as Greece, Ireland, Portugal and Spain,
widening dramatically on fears of possible sovereign defaults.
State defaults in such advanced countries would be unprecedented in the post-war period and would strike a
major blow to the perception of government bonds as a safe asset class. Moreover, they could be
accompanied by dramatic events such as the collapse of local financial sectors, countries leaving the
eurozone, high inflation and perhaps even the confiscation or freezing of some deposits. Given all this, it is
quite possible that the risk of sovereign defaults in the eurozone has contributed to golds continued
strength, and there does seem to be some recent correlation between gold and bond spreads in the
peripherals.

6] Gold and political instability

Another factor that can boost gold prices is political instability. Investor concerns about wars, civil conflicts
and international tensions can boost demand for gold for similar reasons to those noted above for periods of
financial stress. Golds potential function as a currency of last resort in case of serious system collapse
provides a particular incentive to hold it in case the political situation is especially severe.
To some extent, political concerns will also be picked up by financial stress measures, so separating the two is
not entirely straightforward. It is made even more difficult by the absence of clear objective measures of
political risk, which makes it hard to test for the impact of political instability. However, the impact of political
factors does seem to have been especially important in driving gold at certain times. In particular, gold
appears to have been boosted in the late 1970s and early 1980s by incidents such as the Iranian revolution
and the Soviet invasion of Afghanistan. Gold prices also rose sharply in the immediate wake of the September
11 2001 attacks in the US.

7] Gold and official sector activity

The behaviour of central banks and other parts of the official sector can have an important impact on gold
prices. One reason for this is that central banks are big holders of gold, possessing some 30,500 metric tons
in 2010, which is approximately 15% of all above-ground gold stocks. As a result, central bank policies on
gold sales and purchases can have significant effects, and these policies have been subject to considerable
shifts over the decades.
Official sector sales (including the IMF) from 1989-2009 totalled almost 8,000 tonnes and cut official gold
reserves by a fifth while accounting for around 10% of total gold supply. The resultant pushing out of the
gold supply curve may have contributed significantly to the bear market in gold that existed for much of this
period and the temporary obscuring of golds normal relation with other economic variables in the 1990s
noted above.



To some extent, the impact of political factors does seem to have been especially important in driving gold at
certain times. In particular, gold appears to have been boosted in the late 1970s and early 1980s by incidents
such as the Iranian revolution and the Soviet invasion of Afghanistan. Gold prices also rose sharply in the
immediate wake of the September 11 2001 attacks in the US.

Things began to change with the first Central Bank Gold Agreement in 1999 which limited future gold sales.
By removing the threat to the market of accelerated official sales, these agreements helped boost investor
demand for gold.

MODELLING THE PRICE OF GOLD
1) Estimation of a gold price equation
This section details the results of our efforts to formalise the previous analysis of the determinants of gold
prices by estimating an equation to explain both long- and short-run movements in the price of gold.
Despite the importance of gold in central bank reserves and its value to investors as a store of wealth and
potential risk-diversifier, there is relatively little academic literature that attempts to estimate price
determinants. The work that has been done (for example, Levine & Wright (2006), Ghosh et. al. (2002) and
Capie et. al.
(2005)) has highlighted the role of gold as a long run hedge against inflation, short run hedge against
exchange rate movements and a risk-diversifier in investment portfolios. In this section we build on these
efforts, constructing an equation using a variety of explanatory variables in an attempt to capture more fully
the key drivers of the gold price.
Our equation is an error-correction model (ECM) that comprises a long-run element where gold prices move
in line with inflation and a short-run element containing the factors noted in section 2 above, which can cause
large and persistent swings in the gold price independent of the inflation backdrop. These factors include:
The current rate of inflation: a rise in the inflation rate may induce movement into real assets like
commodities which are seen as inflation hedges.
Inflation volatility: rising inflation volatility increases the uncertainty about future returns on non-
inflation proofed assets, and also increases demand for real assets such as gold.
World income: higher income may push up demand for jewellery and industrial uses which can not be
fully met by mining output rises in the short run.
The dollars external value: a US depreciation of the effective dollar exchange rate will tend to push up
the US$ price of gold as described in section 2.4 above.
Real interest rate: higher real interest rates increase the opportunity cost of holding gold and reduce
demand, while low or negative real interest rates raise demand for gold.
Golds Beta8: if the return on holding gold is unrelated to the stock market it can act as a diversifier in
portfolios. A fall in golds beta increases the benefit from this and will push the price up.
Financial stress measures: during periods of financial stress investors move out of risky assets into
safer holdings. A commonly-used measure of stress is the credit default premium, i.e. the difference in
yield between low-rated and highly-rated corporate bonds.
Political risk: in a similar vein to financial stress, increases in political risk are expected to raise the price
of gold.
Official sector activity: the recent rapid expansion of the US Feds balance sheet may have pushed
investors towards gold as a hedge against possible policy mistakes leading to high inflation.
Central bank gold reserve sales: the sale of gold by central banks in the late 1990s may have artificially
depressed the price in this period.
Combining these long and short-run factors we estimated an equation explaining movements in the nominal
price of gold over the period 1976-2010.9 The equation was estimated using quarterly data.
We experimented with a number of specifications incorporating the above factors and some others, but many
were found not to add explanatory power and were dropped from the equation. The final equation related
gold prices to a series of variables including US CPI inflation, the effective dollar exchange rate, real US
interest rates, the default premium (the spread between BBB and AAA-rated corporate bonds) and the US
monetary base.10
The key features of the equation are as follows:
The speed of correction of gold prices in response to a shock is comparatively slow. Deviations of the
gold price from its long run equilibrium can be significant, long-lasting and take years to fully erode.
In the short run previous momentum in the price of gold (as captured by the two previous quarters
price movements) is a significant factor. If the price of gold rises by 10% in the two previous quarters
this will raise the current price by 3.3%, all other things equal.
The effective exchange rate was found to have the strongest contemporaneous statistical relationship
with gold, with a rise in the value of the US$ pushing down the price of gold in US$. A 10%
appreciation of the US$ reduces the price of gold by 8.4% (this is broadly in line with the elasticity
estimated by the IMF noted in section 2.4 above.
The real interest rate captures the opportunity cost of holding gold relative to other risk free assets
which pay a return. As expected, a rise in the real interest rate reduces the price of gold; the equation
suggests that a 100 basis point fall in the real interest rate will result in an initial 1.5% rise in the price
of gold.
The credit default premium captures the risk environment within the financial system. As a result this
term is relatively unimportant in normal times (as the risk premium does not move very much) but in
times of crisis it is a significant driver of the price of gold. A 100 basis point rise in the premium will
increase the price of gold by 4.4% in the following quarter.
As with the credit default premium, the US monetary base is a relatively unimportant determinant of
movements under normal economic conditions but in more recent times it has been a significant
driver of the gold price.11 A 10% point increase in the growth rate of the monetary base results in a
1.4% rise in the price of gold in the current period.

All the above variables had the expected sign and most were significant at the 10% level or better. In addition
to these variables we also found it necessary to include dummy variables for the last quarter of 1979 and the
first two quarters of 1980 to improve the fit of the equation. These dummies aim to capture the major
political disturbances of the period which were not fully picked up by other variables such as the default
premium. The equation also passed the standard robustness tests, and the estimated price tracked the actual
price relatively well over time.




EQUATION DETAILS
In line with the general macroeconometric literature, we have adopted an error correction format to model
the price of gold.20 This format separates the determinants of the price into two components: a long run
relationship and drivers of short run fluctuations.
For the long-run part of the equation we followed the academic literature and assumed that the gold price
has an elasticity of one with respect to inflation in the long run, so that gold and the price level move
together one-for-one over the very long term.21
But whilst this assumption is currently standard, it implies that gold has a zero real rate of return over the
long run. The experience of the past 30 years or so, where the real rate of return to gold has been positive for
long periods of time, suggests that there may be other factors pushing up the price faster than the rate of
inflation. This observation suggests that there may be other factors which determine the long run rate of
return, such as the cost of mining gold, the global rate of inflation and the level of demand (proxied by the
growth in world GDP and world GDP weighted by each countrys demand for gold).
Despite the positive rates of return observed over the last 35 years, our econometric investigation suggests
that over the long term the price of gold is driven by the rate of inflation. As such, we have adopted the long
run model that is consistent with academic literature, and assumed that the gold price and general price level
move together in a one-for-one relationship:
(lnPGt-1 lnCPIt-1)
Where is the error correction term, i.e. the amount by which gold moves toward its long-run equilibrium
value, PG is the price of gold and CPI is the US price level (as defined by the consumer price index).
The coefficient takes a value between 0 and -1; if we start from equilibrium and the price of gold rises faster
than the general price level today, the error correction term will result in gold prices falling tomorrow (other
things equal) to move back towards equilibrium and vice versa if gold prices rise more slowly than the price
level today the error correction term will push gold prices upwards in the following period. The absolute size
of the coefficient determines the speed of adjustment, with a higher value signalling quicker adjustment.

Having established the long run relationship driving the price of gold over the very long term, the short-run
part of the equation seeks to capture the factors responsible for the significant deviation between
movements in the gold price and the price level observed historically. As is standard in the error correction
format, these variables were included as differences rather than absolute levels, so that in the long run (when
the price is in equilibrium) their value is zero.
The movements of the gold price over the short run, in particular the tendency for the price to rise rapidly in
times of crisis but more slowly in more stable periods, suggest that some of the variables outlined above (in
particular the financial stress measures, the exchange rate and monetary policy) may have a non-linear impact
on the price. To test for this, these variables were included with linear terms, squared terms and interaction
terms, which were positive in times of financial stress.
After experimenting with various combinations of different variables and non-linear terms, a final equation
was derived which removed all variables that proved insignificant. The final form of the equation is:
% Ch. PGt = + 1(% Ch. PGt-1) + 2(% Ch. PGt-2) + 3(US Inflation) + 4(% Ch. Ex Ratet) + 5(Ch.
Real Ratet) + 6(Ch. Default Premiumt-1) + 7(Ch in growth rate of US monetary baset) + ECMt-1 +
Time Dummies
Where PG is the price of gold (US$/troy ounce):
is the constant term;
i 7 are coefficients capturing the impact on the price of gold of a 1% change in the variable;
represents the speed of adjustment to the long run equilibrium;
US Inflation is the annual rate of CPI inflation in the US;
Ex Rate is the US nominal effective exchange rate;
Real Rate is the estimated real interest rate (calculated as the five year bond yield minus 5-year
ahead inflation expectations reported by the University of Michigan Consumer survey, i.e. an ex ante
measure of inflation expectations);
Default Premium is the yield spread between BBB-rated corporate bonds and AAA-rated bonds;
US Monetary Base is the seasonally adjusted US monetary base, (US$ millions).
All the variables had the correct sign and most were significant at the 10% level or better. In addition to these
variables, we also found it necessary to include dummy variables for the last quarter of 1979 and the first two
quarters of 1980 to improve the fit of the equation. These dummies aim to capture the major political
disturbances of the period which were not fully picked up by other variables such as the default premium.22
Having done this, the estimated equation passes the standard tests for normality of errors, serial correlation
and heteroskedasticity, and has an R-Squared of 0.54, which is a relatively high value for a differences
equation. The estimated price of gold is close to the actual price of gold in almost all periods and the broad
movements are well tracked over time.

The presence of two lags of the gold price in the estimated equation may suggest that other short run
variables do not have much explanatory power. To test this we re-estimated the final equation but removed
the gold price lag terms. Although the fit worsened (the R-Squared value fell from 0.54 to 0.5) it remained
good. All key changes in momentum remain identified, as do the upward trends in recent years. This suggests
that gold is not strongly affected by its previous values, and other short run determinants such as the
exchange rate and real interest rate are more important determinants of short run shifts in the price.





WHY INVEST IN GOLD?
Of all the precious metals, gold is the most popular as an investment. Investors generally buy gold
as a hedge or harbor against economic, political, or social fiat currency crises (including investment
market declines, burgeoning national debt, currency failure, inflation, war and social unrest). The
gold market is subject to speculation as are other markets, especially through the use of futures
contracts and derivatives. Gold price has shown a long term correlation with the price of crude oil.
This suggests a reason why gold is sold off during economic weakness.
Why to invest in gold? Should I invest in gold? Is gold a good investment option? Why do people invest in
Gold? What are all the benefits of investing in gold?
There are 2 primary reasons why people need to invest in gold. Investing money in gold is worth because it is
a hedge against inflation.1) Over a period of time, the return on gold investment is in line with the rate of
inflation. It is worth investing in gold for a one more very valid reason.2) That is gold is negatively correlated
to equity investments. Say for example 2007 onwards, the equity markets started performing poorly whereas
the gold has performed well. So having gold as an investment option in your portfolio mix will help you
reduce the overall volatility of your portfolio.
The above 2 points could have given some answers to your question Is buying gold a good investment?
This investment proved remarkable from 2006 to 2011.During that time span Gold has given average return
of 29% per annum which was any day better than other investment options. However, the long term average
return on gold investment is less than 10% p.a. As one can say technically or ironically but history always
repeats itself. Therefore, we may once again observe the similar less than 10% appreciation pattern in gold
prices in near future.

How to invest in gold?
India (NRIs included) is crazy about gold jewellery. With the World Gold Council (WGC) aggressively
marketing social and religious functions as gold buying events, the demand has shot up in the recent years to
record levels. Research shows that over 16,000 tonnes of gold is there in Indian households predominantly in
the form of jewellery. The value of this as per market price is a whooping Rs. 27.2 lakh crore. That is close to
twice the foreign exchange reserves held by the RBI. Let's consider the factors one needs to be aware of and
the know-how of investing in gold.
1.Forms of buying gold
Any investor has to be aware of the different forms of buying gold. Jewellery, the most traditional and the
dominant form of buying gold in India, is in fact not an investment idea. The reason is that there are heavy
losses in the form of wastage and making charges. This can vary from a minimum of 10 per cent to as high as
35 per cent for special and complex designs.

Bank coins, again, are not an investment idea as the premium that banks charge for their coins is around 5-10
per cent. Also, the bank coins have lesser liquidity as they are not bought back by the banks.

Bullion bars are good modes for investment but the minimum investment here is much higher than a
common investor can think of.

Gold Exchange Traded Funds (ETFs) are a hot option these days. These are like mutual funds that invest only
in gold. They are proving to be an easier and safer mode to buy gold. The charges are very less and the gold
can be accessed electronically. The disadvantage is that one never gets to "see" one's holdings.
2. Current income
Gold in any form does not give any current income. The only exception is the dividend option in the gold
ETFs. If held in the physical form, there is only outflow of cash for the maintenance of lockers.

3. Capital appreciation
Historically, gold has been the perfect hedge for inflation. This is based on data from the year 1800 AD. But in
terms of absolute returns gold has fared rather poorly giving returns at only 0.8 per cent above inflation. Real
estate and shares beat gold squarely on the capital appreciation front. Real estate and shares have given
returns of about 11 per cent over inflation since 1979 (1979 as that was the year the Sensex was launches).

In the short run, however, gold is a very strong bet compared to shares that are highly volatile. The idea for
gold investment will be to use it at times when the markets are falling and when the inflation is very high.

A 5 per cent of the overall investment portfolio can be considered for gold investments (bullion, WGC coins,
Gold ETFs). Jewellery is not an investment as far as personal finance goes. It is only an expense for pleasure,
symbolizing wealth.

4. Risk
Gold does not carry much risk at least in India, as we hardly see deflation in the real sense. Even when the
official figures where showing negative inflation (deflation) during the last year, the actual prices of food
items were increasing. This was reflected in the gold prices too.

The real risk with buying gold is in the opportunity cost of investing in other avenues that can actually give
higher returns.

5. Liquidity
Gold scores the highest in terms of liquidity, compared to all other investments. At any time of the day and
any day gold can literally be converted to cash. Banks would give you a jewellery loan (remember though that
many banks do not give loans on coins, including their own), and so would your friendly neighborhood pawn
shop. They can also be sold in some pawn shops, though many are cautious to purchase in these outlets for
fear of 'stolen jewellery'.
Gold jewelers would exchange your gold possessions for other gold jewels. But the problem here is that there
is going to be making and wastage charges involved again. Here we lose the value (to the extent of 10-35 per
cent) of gold jewels.
An unfortunate social aspect in most families in India related to liquidity is that gold has sentiments attached
and is the last item to leave the house in case of financial difficulties.
This negates the entire purpose of gold having liquidity.

6. Tax treatment
Gold suffers capital gains tax as per the IT Act. So it is better to ask your jeweller for the bill. Close to 90 per
cent of the gold jewellery traded in India is unbilled. This is a serious problem for those who look at gold as
an investment. Only the branded jewellers would automatically give you a bill. At other places ask for one.
We can make use of indexation benefits when calculating the capital gains of gold. So the tax payable will not
be much. Gold does not have any other tax benefits.

7. Convenience
Gold scores very high here. But with the per gram price rising, the smallest single investment is becoming
higher. With the emergence of golf ETFs the convenience to hold gold for the short term has increased.
Instead of holding cash for the short term, one can today make investments in gold ETFs.
INVESTORS SHOULD ALSO LOOK AT THE DISADVANTAGES OF
INVESTING IN GOLD:
No regular income : Gold investment does not provide any current income like dividend or rental as in
Stocks or real estate where investors can reap the rewards of their investment without having to sell their
asset.
Problems in Physical storage : Lack of investment in gold is the factor of storage / treatment / handling.
Storing Gold in large quantities relatively risky and expensive. However, there are possibilities for gold
investment in a form of a certificate or an account in which the owner does not held the physical gold but
later can represent it. Although there are well established forms of gold investment today, some may still
wonder whether such form of gold investment will be still equally reliable in case of a system breakdown.
Also, if storage is not good, though wrapped in protective cover, allowing the oxidation and discoloration.
No Financing or Leverage: When you invest in gold, you will need to have all of the cash on hand to
make a purchase. You cannot use leverage, or any type of financing, for this type of investment or
purchase. This can severely limit the amount of people that can get involved in the market.
No Tax Advantage: Investing in gold is not going to provide you with any type of tax advantage in contrast
to other tax saving instruments available in market.

Subject to Confiscation: One of the biggest risks of investing in gold is that it is subject to confiscation. The
government could come in and confiscate all of the gold in a warehouse if they deem it necessary. In that
case, there is nothing that you can do about it and you will lose your investment.

Actual returns are less than nominal returns: If gold does go up in value, the gain is nominal rather
than an actual increase in buying power. This is because when gold appreciates it typically coincides with
devaluation for paper money. Moreover, those gold profits are taxable.
The biggest disadvantage of investing in gold is its tentative nature. As such, it is not at all possible to
forecast the value of gold in the future. The gold market is dependent not only on the demand and supply to
a great extent but also on the investors expectations.
difficulty in finding buyers for second hand gold coins and gold bars.

Gold has proved itself time and again to be the perfect hedge for inflation. But to look at it as a hedge
avenue, Indians are yet to consider this market actively as the purchases continue to be dominated by
jewellery. Gold only beats inflation. It fares poorly when compared to real estate or shares when compared
on the basis of real inflation adjusted returns.
Any serious investor, however, is advised to have a certain percentage of investment in gold to hedge
inflation.
Foreign Exchange Reserve
Definition
Foreign-exchange reserves (also called forex reserves or FX reserves) are assets held by central banks
and monetary authorities, usually in
different reserve currencies, mostly the
United States dollar, and to a lesser
extent the euro, the United Kingdom
pound sterling, and the Japanese yen,
and used to back its liabilities, e.g., the
local currency issued, and the various
bank reserves deposited with the
central bank, by the government or
financial institutions. Foreign Exchange
reserves are called Reserve Assets in
the Balance of Payments and are
located in under the financial account.
Hence, they are usually an important
part of the International Investment
Position of a country. The reserves are
labeled as reserve assets under assets
by functional category
In terms of financial assets classifications, the reserve assets can be classified as Gold bullion,
unallocated gold accounts, Special drawing rights, currency, Reserve position in the IMF, interbank
position, other transferable deposits, other deposits, debt securities, loans, equity (listed and
unlisted), investment fund shares and financial derivatives, such as forward contracts and options.
There is no counterpart for reserve assets in liabilities of the International Investment Position.
Usually, when the monetary authority of a country has some kind of liability, this will be included in
other categories, such as Other Investments. In the Central Banks Balance Sheet, foreign exchange
reserves are assets, along with domestic credit.
Purpose
Reserve assets could be defined with respect to assets of monetary authority as the custodian, or of
sovereign Government as the principal. For the monetary authority, the motives for holding reserves
may not deviate from the monetary policy objectives, while for Government, the objectives of
holding reserves may go beyond that of the monetary authorities. In other words, the final
expression of the objective of holding reserve assets would be influenced by the reconciliation of
objectives of the monetary authority as the custodian and the Government as principal. There are
cases, however, when reserves are used as a convenient mechanism for Government purchases of
goods and services, servicing foreign currency debt of Government, insurance against emergencies,
and in respect of a few, as a source of income.
The Dominant objectives of the Foreign Exchange Reserve are as follows:
A. Maintaining confidence in monetary and exchange rate policies.
B. Enhancing capacity to intervene in forex markets.
C. Limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks
during times of crisis including national disasters or emergencies.
D. Providing confidence to the markets especially credit rating agencies that external obligations
can always be met, thus reducing the overall costs at which forex resources are available to all
the market participants.
E. Incidentally adding to the comfort of the market participants, by demonstrating the backing
of domestic currency by external assets.
At a formal level, the objective of reserve management in India could be found in the RBI Act, where
the relevant part of the preamble reads as to use the currency system to the countrys advantage
and with a view to securing monetary stability. This statement may be interpreted to hold that
monetary stability means internal as well as external stability; implying stable exchange rate as the
overall objective of the reserve management policy. While internal stability implies that reserve
management cannot be isolated from domestic macroeconomic stability and economic growth, the
phrase to use the currency system to the countrys advantage implies that maximum gains for the
country as a whole or economy in general could be derived in the process of reserve management,
which not only provides for considerable flexibility to reserve management practice, but also
warrants a very dynamic view of what the country needs and how best to meet the requirements. In
other words, the financial return or trade-off between financial costs and benefits of holding and
maintaining reserves is not the only or the predominant objective in management of reserves.
Foreign Exchange Reserve in India
The foreign exchange reserves include three items; gold, SDRs and foreign currency assets. Ason
November 22, 2013, out of the US$ 286,263.7 million of total reserves, foreign currency assets
account the major share at US$ 258,664.7 million. Gold accounts for about US$ 21,227.3 million,
SDRs accounts for US$ 4,420.7 million, Reserves position in the IMF accounts for US$ 1,951.0 million
. In July 1991, as a part of reserve management policy, and as a means of raising resources, the
Reserve Bank temporarily pledged gold to raise loans. The gold holdings, thus have played a crucial
role of reserve management at a time of external crisis. Since then, Gold has played passive role in
reserve management.
From the chart we can
observe that Indias
Foreign Exchange
reserve has changed
over the years. In 1991
gold contributed around
60% of the total foreign
exchange reserves while
foreign currency assets
share was around
38%.This has drastically
changed over the years
with gold share dropping
to around 7.42% and foreign currency assets
increased around 90.21%.
The Chart gives us the trend in the foreign
exchange reserves from 1991 till 2013. It has
been observed that Indias foreign exchange
reserve have increased significantly since
1991.The level of foreign exchange reserve
has steadily increased from US$ 5.8 billion to
US$ 286 billion in 2013. Two factors
responsible for significant addition to foreign
exchange reserve over the years can be
attributed to (i) lower level of current account
deficit (CAD) and,(ii)high capital inflows.

As on 22nd November 2013
US$ Bn
% of Total
Forex Reserve
Foreign Currency Assets 258.66 90.37%
Gold 21.23 7.42%
SDRs 4.42 1.54%
Reserve Position in the
IMF 1.95 0.68%
Total Reserves 286.23 100%
Gold Reserves
As it is already mentioned earlier that in the foreign exchange reserve there is a significant portion
which is constituted by gold.The gold plays important role in the foreign exchange as it provides
diversity to the portfolio and provides lesser correlation with other portfolio options. Gold is also
vital because of its liquidity and limited supply. But given the advantages of gold and its high price it
is not possible to have the entire reserve made up of gold, because Indias production of gold is far
more less compare to its consumption.
Golds Impact on Foreign Exchange Reserve.
India is known to be among the largest importers of gold in the world. The imports of gold by India
have been rising unabated in recent years notwithstanding the sustained increase in gold prices.
Such large import of gold, when the gold prices are ruling high is one major source of bulging trade
deficit. The deterioration in current account deficit (CAD) due to large gold imports has implications
for financing the same, which would reduce the foreign exchange reserves and could become a drag
on the external debt. In this context, a major concern emerged is the impact of huge gold imports
on external stability.
During 2011-12, high trade deficit caused, inter alia, by high gold imports led to worsening of the
CAD. Had the gold imports in India grown by 24 per cent (an average of growth in world gold
demand during part three years) instead of 39 per cent in 2011-12, the current account deficit would
have been lower by approximately US$ 6 billion and CAD-GDP ratio would have been 3.9 per cent
instead of 4.2 per cent. Thus, gold imports are putting pressure on the Balance of Payments
management. The trend in quantum of gold imports appeared to be making Indias external sector
vulnerable in terms of rising trade and current account deficits, which in the absence of adequate
foreign capital flows, will have implications for maintaining adequate foreign exchange reserves
buffer.
Recently to curb down the import of gold and
reduce the CAD the Government has taken
several steps which areby increasing the import
duty on gold and also prescribing restrictions.
Currently India imported just 2.5 tonnes of gold
in August 2013 and it cost $650 million.
Previously it had imported 47.5 tonnes imported
in July 2013, 31.5 tonnes in June 2013, 162
tonnes in May 2013 and 142.5 tonnes in April
2013.Restrictions as mentioned earlier as
prescribed by RBI to control the import of Gold
to reduce the CAD and save the foreign
exchange reserve form being depleted, these
restrictions are as follows:

Year Merchandise Exports Merchandise Imports Trade balance
2000-01 45,452.00 $ 57,912.00 $ (12,460.00) $
2001-02 44,703.00 $ 56,277.00 $ (11,574.00) $
2002-03 53,774.00 $ 64,464.00 $ (10,690.00) $
2003-04 66,285.00 $ 80,003.00 $ (13,718.00) $
2004-05 85,206.00 $ 118,908.00 $ (33,702.00) $
2005-06 105,152.00 $ 157,056.00 $ (51,904.00) $
2006-07 128,888.00 $ 190,670.00 $ (61,782.00) $
2007-08 166,162.00 $ 257,629.00 $ (91,467.00) $
2008-09 189,001.00 $ 308,521.00 $ (119,520.00) $
2009-10 182,235.00 $ 300,609.00 $ (118,374.00) $
2010-11 250,468.00 $ 300,609.00 $ (50,141.00) $
2011-12 305,963.90 $ 489,319.50 $ (183,355.60) $
2012-13 300,400.70 $ 490,736.70 $ (190,336.00) $
2013-14 (
1st Qtr) 72,394.44 $ 122,700.51 $ (50,306.07) $
Source: RBI
INDIA'S BALANCE OF PAYMENTS (US $ Million)
It shall be incumbent on all nominated
banks/nominated agencies to ensure
that at least one fifthof every lot of
import of gold (in any form/purity
including import of gold coins/dore) is
exclusively made available for the
purpose of export. Such imports shall
be linked to financing of exporters by
the nominated agencies (i.e. average of
last three years or any one year
whichever is higher). Further, they shall
make available gold in any form for
domestic use only to entities engaged
in jewellery business/bullion dealers supplying gold to jewelers.
They will be required to retain 20 per cent of the imported quantity in the customs bonded
warehouses.
They are permitted to undertake fresh imports of gold only after the exports have taken place
to the extent of at least 75 per cent of gold remaining in the customs bonded warehouse.
With the implication of such restrictions and laws it is expected to decrease the import of gold and
thereby reduce the CAD to 3.7 percent of the gross domestic product (GDP). The below charts shows
the implications of import of gold on trade balance, the two charts as currency well as the bar
diagram represents separately as to what would had been the trade balance with or without the
import of gold.

$-
$20,000.00
$40,000.00
$60,000.00
$80,000.00
$100,000.00
$120,000.00
$140,000.00
$160,000.00
$180,000.00
$200,000.00
Comparative Study
Trade balance(Without) Trade balance
Year Merchandise Exports Merchandise Imports
Trade
balance(Without)
2000-01 45,452.00 $ 53,790.40 $ (8,338.40) $
2001-02 44,703.00 $ 52,106.60 $ (7,403.60) $
2002-03 53,774.00 $ 60,619.10 $ (6,845.10) $
2003-04 66,285.00 $ 73,486.10 $ (7,201.10) $
2004-05 85,206.00 $ 108,370.30 $ (23,164.30) $
2005-06 105,152.00 $ 146,225.50 $ (41,073.50) $
2006-07 128,888.00 $ 176,208.10 $ (47,320.10) $
2007-08 166,162.00 $ 240,905.40 $ (74,743.40) $
2008-09 189,001.00 $ 287,795.40 $ (98,794.40) $
2009-10 182,235.00 $ 271,968.90 $ (89,733.90) $
2010-11 250,468.00 $ 347,059.30 $ (96,591.30) $
2011-12 305,963.90 $ 427,917.74 $ (121,953.84) $
2012-13 300,400.70 $ 435,059.11 $ (134,658.41) $
2013-14 (
1st Qtr) 72,394.44 $ 104,674.50 $ (32,280.06) $
Source: RBI
INDIA'S BALANCE OF PAYMENTS EXCLUDING IMPORT OF GOLD (US $ Million)
International Monetary Fund

An international organization of 188 countries, formally created in 1945.

The work of the IMF is of three main types.
Surveillance involves the monitoring of economic and financial developments, and the
provision of policy advice, aimed especially at crisis-prevention.
IMF also lends to countries with balance of payments difficulties, to provide temporary
financing and to support policies aimed at correcting the underlying problems; loans to low-
income countries are also aimed especially at poverty reduction.
IMF provides countries with technical assistance and training in its areas of expertise.
Supporting all three of these activities is IMF work in economic research and statistics.
IMF AND GOLD
The IMF holds a relatively large amount of gold among its assets, not only for reasons of financial
soundness, but also to meet unforeseen contingencies. The IMF holds about 90.5 million ounces,
or 2,814.1 metric tons, of gold at designated depositories. The IMF's total gold holdings are
valued on its balance sheet at about $4.9 billion (SDR 3.2 billion) on the basis of historical cost.
Gold played a central role in the international monetary system after World War II. The countries
that joined the IMF between 1945 and 1971 agreed to keep their exchange rates pegged in terms
of the dollar and, in the case of the United States, the value of the dollar in terms of gold. This
"par value system" ceased to work after 1971.
Until the late 1970s, 25 percent of member countries' initial quota subscriptions and
subsequent quota increases had to be paid for with gold. Payment of charges and repayments to
the IMF by its members constituted other sources of gold.
BAD FOR: The IMF's Articles of Agreement strictly limit the use of the gold following the Second
Amendment in 1978. But in some circumstances, the IMF may sell gold or accept gold as
payment from member countries.
The selling of gold by the IMF is rare as it requires an Executive Board decision with an 85 percent
majority of the total voting power. Prior to the recent sale of gold, the last time gold was sold by
the institution was through off-market transactions completed in April 2001, with 12.9 million
ounces traded. This transaction was approved by the membership as a means to finance the
IMF's participation in the Heavily Indebted Poor Countries Initiative and the continuation of
the Poverty Reduction and Growth Facility.

WHY BUYING GOLD IN INDIAN ECONOMY?
As discussed earlier,every year, India spends millions of dollars to import gold. This puts undue
pressure on the rupee which results in its weakening against the dollar. Cost of imports puts
enormous pressure on the countrys current account deficit(CAD).Although, oil and gold make up
70% of Indias $175 billion trade deficit, but given our current account deficit and the need to
conserve foreign exchanges to import other important essential items, like oil, gas, coal, edible oil,
machinery etc., Indias appetite for gold must be conserved.

IMF & INDIA

IMF has played an important role in the Indian economy. It has provided economic and technical
assistance to India from time to time. India joined the IMF on December 27, 1945, as one of the
IMF's original members.
Financial Assistance
While India has not been a frequent user of IMF resources, IMF credit has been instrumental in
helping India respond to emerging balance of payments problems on two occasions. In 1981-82,
India borrowed SDR 3.9 billion under an Extended Fund Facility, the largest arrangement in IMF
history at the time. In 1991-93, India borrowed a total of SDR 2.2 billion under two stand-by
arrangements, and in 1991 it borrowed SDR 1.4 billion under the Compensatory Financing Facility.
Technical Assistance
In recent years, the Fund has provided India with
technical assistance in a number of areas, including the
development of the government securities market,
foreign exchange market reform, public expenditure
management, tax and customs administration, and
strengthening statistical systems in connection with the
Special Data Dissemination Standards. Since 1981 the
IMF Institute has provided training to Indian officials in
national accounts, tax administration, balance of
payments compilation, monetary policy, and other
areas. India took loans from IMF thrice on
November, 9, 1981; January 18, 1991, and October 13,
1991, to the tune of $3.9 billion special drawing rights (SDRs), $551.93 million SDRs and $1,656
million SDRs respectively.
India's forex reserves had depleted to $1.2 billion in January 1991, and that too dried up by half by
June of that year. This forex reserves could finance only three weeks of essential imports. India had
to pledge 67 tonne of gold reserves to seek the IMF loan.India had faced a number of weaknesses
which are now aggravated by the squeeze in global liquidity.
India became a creditor to the International Monetary Fund in May 2003 on the basis of its strong
balance of payments and foreign exchange reserves position. India contributed $498 million to
the IMF's Financial Transaction Plan, thus turning from a debtor into a lender to the IMF. It made
a contribution of $498 million to the International Monetary Fund.

In 2009, International Monetary Fund sold 200 metric tons of gold to the Reserve Bank of India for
about $6.7 billion, quietly executing half of a long-planned bullion sale that threatened to slow
gold's ascent.
The deal increased India's gold holdings to the tenth largest among central banks and lifted its share
of gold holdings from nearly 4% to about 6%, much less than most of the developed world but four
times China's share.The gold purchase was done as part of Reserve Banks foreign exchange reserves
management operations.Indias foreign-exchange reserves advanced $684 million to $285.5 billion
in the week.That included foreign-currency assets of $268.3 billion, gold reserves of $10.3 billion and
the special drawing rights with the IMF.
India had built up its gold reserves to over 20 percent of its foreign reserves in 1994 after a balance
of payments crisis in 1991. But the proportion of gold fell significantly as total reserves swelled.The
reason behind the buying was India's push for a larger voting share in the IMF.
India, with other emerging economies pressed for greater influence in world economic affairs as it
has grown rapidly into a $1.2 trillion economy.
Recently, there were speculations that India might pledge gold with IMF to get loan to prop up the
falling rupee.However, the Economic Affairs Secretary, Arvind Mayaram clarified that the
government will not consider raising cash loan by swapping the IMF-bought 200 tons gold for
payable currency.Reserve Bank of India governor, Raghuram Rajan said, that India will not need to
go to the International Monetary Fund (IMF) for funds in the next five year and the country is not
confronting any financial or economic crisis. India's external debt to GDP is 22 per cent and India has
reserve of $280 billion, which is 15 per cent of GDP. In other words, the country can pay three-fourth
of its debt from its forex reserves.
The country currently holds the worlds 11th largest gold reserves. According to World Gold Council
(WGC) statistics dated July 2013, the official gold holdings by the country stand at 557.7 tons,
constituting 8.6% of the national forex reserves.
GOLD ETFs
What is Gold ETF?
Gold Exchange Traded Funds (ETF) is an open-
ended mutual fund whose units represent physical
gold that is 99.5% pure, with each unit representing
1 gram of gold. These units are traded on the stock
exchanges like a single stock of a company.
How to buy Gold ETF
One of the factors that gives an edge to gold ETFs
is its ease of buying. If you have a Demat account ,
you can buy gold ETFs as you buy Shares. Or u can
contact a Stock brocker , open a demat account and buy.
Advantages of gold ETF
Gold ETFs provide an opportunity to investors to accumulate gold over a given period of time. Since
it can be purchased in small quantities, one can plan the procurement as per future requirements,
say, for the marriage of children, etc.
Moreover, there is no risk of theft and one need not worry about the storage (as in case of physical
gold) because such units are held in demat or paper form.
In the case of physical gold, one ends up paying extra for making charges as well, but there is no
extra charge applicable in gold ETFs. When needed, one can exchange them in multiples of 1 kg
units of 0.995 purity
Can be sold at transparent prices across India. Even in terms of taxation benefits, gold ETFs are way
ahead of the physical gold. No sales tax, VAT or securities transaction tax is applicable on gold ETFs.
As units of such funds are traded like stocks on the exchange, it is eligible for the long-term capital
gains after one year, unlike physical gold, which is eligible for long-term capital gains after three
years.
Besides, unlike physical gold, investors don't have to pay wealth tax on gold ETFs.


Few drawbacks of Gold ETFs
The annual expenses of the fund such as storage, insurance, and management fees are charged by
selling a small amount of gold represented by each share, so the amount of gold in each share will
gradually decline over time
Moreover, there are additional costs involved at the time of buying and selling in the form of
brokerage or commission.
Another drawback with gold ETFs is liquidity; not all ETFs are liquid, which impacts their buying and
selling flexibility.
Trends in Gold ETF
The global trend : The total gold holdings of the world against ETFs can be seen as increasing by a
good amount every year from 2003-2012.

The trends in india
Price of gold ETFs
It can be seen from the diagram below that the price of gold ETFs has been constantly on the rise,
which confirms that the demand in the Indian market for gold ETFs is rising.



Price of gold ETF Turnover of gold ETF in NSE.
The above right diagram shows increase in turnover of gold ETFs in the National Stock
Exchange(NSE). The turnover has been multiplying year by year from 2007-2011.


Current Scenario
The government had raised customs duty on standard gold to 10% from 2% over about two years to
contain imports that bloated the current account deficit to an all-time high of 4.8% of gross
domestic product, or $88 billion, in the year to March. The country spent $56.8 billion of its precious
foreign exchange reserves on gold imports in the last fiscal year.
The high current account deficit and concerns over its funding were largely responsible for the rupee
plummeting in August after the US Federal Reserve signalled its intention of rolling back its stimulus
programme, an action it hasn't begun as yet. As part of the steps to clamp down on gold imports,
the Reserve Bank of India had in July introduced an 80:20 scheme - 20% of the bullion imported had
to be exported back. Imports were also not allowed if importers were unable to meet the 20%
norm.
The government also banned trading of gold in special economic zones.

The measures had the desired impact of slowing down gold and silver imports to $25.5 billion in first
eight months of the fiscal from $33.5 billion in the year earlier. The fall has been more dramatic of
late with imports dropping to $1.2 billion in November. Meanwhile, the rupee strengthened over
10% to 62.19 to the dollar as of the Friday close from the record low of 68.81 in August.
But a section of the government is beginning to worry about ramifications of these measures - rise
in smuggling, loss of import duty, decline in remittances, effect on small traders and pending
demand building up.
Communication from the ministry of finance said A review of the duty structure and the measures
to restrict exports is expected by this month end.
Also the big players in the gold game has lobbied hard with the government to ease the measures.
We strongly believe that now the central bank will ease the tough restriction in a calibrated manner
on the metals import following the dramatic improvement in the current account deficit and the rise
of unintended consequences.






References
http://www.imf.org/external/np/tre/liquid/2013/1013.htm
http://www.imf.org/external/about/gold.htm
http://www.imf.org/external/np/exr/facts/gold.htm
http://www.imf.org/external/NP/EXR/faq/goldfaqs.htm
http://www.imf.org/external/np/sec/pr/2009/pr09381.htm
http://www.imf.org/external/np/exr/facts/gold.htm
http://www.imf.org/external/country/IND/index.htm
http://blogs.reuters.com/financial-regulatory-forum/2009/11/03/india-buys-half-of-imfs-gold-for-sale-whos-
next/
http://www.worldgoldcouncil.com
http://www.rbi.org
Articles from - Times of India, The Indian Express.
IDFC Forex Reserve Report.
Foreign Exchange Markets - by Rajesh Chakrabarti
Indias Gold Rush-C.P. Chandrasekhar