The Gold Price Crash

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Haven't you played with bubbles when you were young? You blew them out of a small bottle and these bubbles rose in the air .After flying for some time they burst. Doesn't this remind you of the speculative bubbles that occur in Commodities, Real Estate and so on? Isn't this similar to a balloon where you continuously blow it up with air and after sometime it bursts? This is the same thing that happens in gold. Here a spike in the prices of a commodity like gold is caused due to the exaggerated expectations of growth followed by a rapid price rise. When these expectations are not met the rapidly rising prices are followed by a great fall….This is the speculative bubble….Here we have the famous proverb "Do Not Look Where You Fell But Where You Slipped". This tells us how experience is a great teacher. Here even though we fall we must rise again

 

We all noticed a strange phenomenon in the month of April. Gold which was rising at tear away prices suddenly experienced a great fall crashing to an 18 month low. So why did this happen? The answer lies in a small tax haven island country in the Mediterranean Sea. This country a tax haven propped up by loads of Russian money .The Russian Elite and Wealthy stashed their wealth most of it ill gotten in the offshore tax haven of Cyprus. So Why Did Cyprus Banks Collapse?

·         The country's largest banks had a heavy exposure to Greek bonds, being neighbors a huge quantity of Greek bonds were absorbed by Cyprus. The falling land prices in Cyprus further accentuated the crisis and caused a solvency crisis for these banks as they held huge quantity of Cypriot land.

·         The currency of Cyprus is the Euro as they had recently joined the Euro zone. They required a bailout package from the European Central Bank because Cyprus uses the Euro. Cyprus has no capital gains tax and a corporate taxation of just 10%.

·         Here a large number of depositors in Cyprus main banks were Russians. The strongest economy in Europe is Germany, and the Germans have a huge say in the bailout packages of the European Central Bank. The Germans were loathe to help the Russians as they felt the rich Russians should pay their way out.

·         The European Central Bank agreed for a bailout subject to certain conditions. The Cypriots should pay a part of the bailout package themselves. Here all deposits above 1,00,000 Euros would take a 9.9% hit. Below 1,00,000 Euros a 6.75% hit. All accounts below 1,00,000 Euro's have a Depositors Insurance. In spite of this people queued up to withdraw their deposits. They were obviously not allowed to do so as the daily cash withdrawal limit from the ATM was 300 Euros. The amount of cash travelers could take out of the country ranged from 2000 Euros later increased to 3000 Euros .Businesses could transfer 3,00,000 Euros for domestic transactions but amounts above that required certification. Basically Cyprus introduced capital controls in order to protect its banks.

 

So What Finally Happened:

·         After much haggling in the parliament, Cyprus second most largest bank Laiki was shut down. All deposits below 1,00,000 Euros where transferred to the Bank Of Cyprus. All deposits below1,00,000 Euros would be insured completely. Those above 1,00,000 Euros would take a big hit losing up to 40% of the amount deposited. The major losers would be the Cypriots with over 1,00,000 Euros .Imagine a guy who has taken a huge loan and finds 40% of the amounts gone from his accounts. Obviously he has to pay back the full loan. The Russians would somehow escape transferring their money to another tax haven. The Greek defaulters would escape. Truly we live in a multi polar world.

·         Here the parliament voted in favor of the bailout packages which results in wealthy citizens of Cyprus losing a lot of money, Major banks shutting down and Cyprus international tax haven status in the doldrums.

·         Here Cyprus secured a 10 Billion Euro bailout and continues to remain in the European Union.

I Understand All This But What Has This To Do With The Gold Price Crashing:

·         Here Cyprus pledged to sell a part of its gold reserves to fund the bailout .Cyprus has a total of about 14 Tonnes of Gold .This translates to a minuscule amount. Here Cyprus was not promised more funds in bailouts no matter what its financial status was and even though it required maybe 2-3 times the sanctioned amount. There are other bigger nations such as Spain, Portugal, Italy and Hungary whose central banks might be forced to sell Gold Bullion to fund their bailout packages thereby flooding the markets with gold. Obviously with such plentiful supply the prices of gold would have to come down. Here even though Cyprus is a small problem it is a symbol of a much bigger Contagion.

We Are The Highest Net Importer Of Gold So What Effect Would This Have On Our Current Account Deficits:

·         Here a current account deficit is when a country's government, businesses and individuals imports more goods and services and capital than it exports. Here we have a trade deficit where the country imports more goods and services than it exports. This is the largest component of the current account deficit. The second largest deficit is when payments made to foreigners by Indian/Indian government is greater than the wages, interest, and dividends made by the foreigners to Indian residents. The smallest component would be Indian government grants to foreigners. Here in the pharmaceutical category we see patents, product development and so on. We are a nation of gold importers because of our craze for the yellow metal. The world's largest consumer of gold drove the demand for gold in the global market in the fourth quarter ending December 2012 with a whopping 41% year on year increase. So What Happened To Our Current Account Deficit Due To Ihe Importing Of Gold? India's current account deficit widened to a record 6.7% of GDP in Q4 led by higher gold imports. According to the finance minister Mr Chidambaram about 80% of this is due to gold imports as India and China together account for about 45% of the world's gold demand .Here India imported a record 255 tonnes in the October-December Q4 2012 .Here India's gold import bill for the year 2012 crossed 40 Billion Dollars. Here in April 2013 we noticed a crash in the gold and oil prices which is good for the Indian Macro economy at large. Here we would notice a moderate fall in Wholesale price index, fall in inflation, Governments fuel and fertilizer bill subsidy, which provides room to policy holders to perhaps cut the interest rates. Here it is anticipated that the gold import bill will go down by 8 Billion Dollars due to the crash in prices in this year. Here we had an average Current Account Deficit Of 5.3% of Gross Domestic Product in the year 2012.This is expected to reduce to about 4.3% of the Current Account Deficit. Truly a God Sent Blessing…

 

So Who Loses Out On This God Sent Opportunity:

·         Gold loan financiers expanded at an astronomical rate in the years 2010-2011 when gold prices skyrocketed .Now these are under heavy losses. So What Went Wrong?

·         RBI got worried about the meteoric rise of these companies and capped the loan to value ratio at 60% brought down from 75%.This basically means that against gold jewellery pledged , only 60% of the value would be given as loans.

·         Only gold jewellery could be pledged and not gold coins or gold bars.

·         The interest rates here range from 22% to around 24%.

 

Why Are The Gold Loan Financiers Worried?

·         The RBI has reduced the loan to value ratio to 60% from around 75%.These gold loan financing companies charge an interest rate of around 22%.Earlier they could have lent INR 75 for every INR 100 of Gold Jewellery pledged. Now they can lend only INR 60 for every INR 100 of Gold Jewellery pledged. Here they lose INR 3.3 for every INR 100 of gold jewellery pledged. This translates to about INR 33000 for INR 10 Lakhs of gold jewellery pledged. Quite a Loss…

·         These Gold Loan Financing companies were required to maintain a higher capital of 12% by April 1^st 2014.These were done to avoid risks to banks and the public at large due to their exposure to debentures of these companies.

·         We saw in the month of April the price of gold crashing. This exposes these gold loan financiers to default mainly by those who had pledged their gold at a higher 75% loan to value ratio when the prices of gold where sky high.

 

I would like to end this article with the phrase "As Gold Is Tried By Fire So Are Brave Men By Adversity."Let us not lose heart by this gold crash and just as "The Darkest Hour Is Just Before The Dawn" gold too will once again have its "Hay Days In The Sun".

Happy Investing!!

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