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Introduction

Gold is a unique asset based on few basic characteristics. First, it is primarily a monetary asset,and partly a commodity. As much as two thirds of gold’s total accumulated holdings relate to“store of value” considerations. Holdings in this category include the central bank reserves, private investments, and high-cartage jewelry bought primarily in developing countries as avehicle for savings. Thus, gold is primarily a monetary asset. Less than one third of gold’s totalaccumulated holdings can be considered a commodity, the jewelry bought in Western marketsfor adornment, and gold used in industry. The distinction between gold and commodities isimportant. Gold has maintained its value in after-inflation terms over the long run, whilecommodities have declined. Some analysts like to think of gold as a “currency without acountry’. It is an internationally recognized asset that is not dependent upon any government’s promise to pay. This is an important feature when comparing gold to conventional diversifierslike T-bills or bonds, which unlike gold, do have counter-party risk

Why gold is "good as gold" is an intriguing question. However, we think that the more pragmatic ancient Egyptians were perhaps more accurate in observing that gold's value was afunction of its pleasing physical characteristics and its scarcity.

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Gold is primarily a monetary asset and partly a commodity.

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More than two thirds of gold's total accumulated holdings account as 'value for investment'with central bank reserves, private players and high-carat Jewellery.

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Less than one third of gold's total accumulated holdings is as a 'commodity' for Jewellery inWestern markets and usage in industry.

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The Gold market is highly liquid and gold held by central banks, other major institutionsand retail Jewellery keep coming back to the market.

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Due to large stocks of Gold as against its demand, it is argued that the core driver of thereal price of gold is stock equilibrium rather than flow equilibrium.

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Economic forces that determine the price of gold are different from, and in many casesopposed to the forces that influence most financial assets.

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South Africa is the world's largest gold producer with 394 tons in 2001, followed by USand Australia.

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India is the world's largest gold consumer with an annual demand of 800 tons

What makes Gold different from other commodities?

The flow demand of commodities is driven primarily by exogenous variables that are subject tothe business cycle, such as GDP or absorption. Consequently, one would expect that a suddenunanticipated increase in the demand for a given commodity that is not met by an immediateincrease in supply should, all else being equal, drive the price of the commodity upwards.

However, it is our contention that, in the case of gold, buffer stocks can be supplied with perfectelasticity. If this argument holds true, no such upward price pressure will be observed in thegold market in the presence of a positive demand shock.The existence of a sophisticated liquid market in gold has, over the past 15 years, provided amechanism for gold held by central banks and other major institutions to come back to themarket. Although the demand for gold as an industrial input or as a final product (jewellery)differs across regions, it is argued that the core driver of the real price of gold is stock equilibrium rather than flow equilibrium. This is not to say that exogenous shifts in flowdemand will have no influence at all on the price of gold, but rather that the large supply of inventory is likely to dampen any resultant spikes in price. The extent of this dampening effectdepends on the gestation lag within which liquid inventories can be converted in industrialinputs. In the gold industry such time lags are typically very short.Gold has three crucial attributes that, combined, set it apart from other commodities: firstly,assayed gold is homogeneous; secondly, gold is indestructible and fungible; and thirdly, theinventory of aboveground stocks is astronomically large relative to changes in flow demand.One consequence of these attributes is a dramatic reduction in gestation lags, given low searchcosts and the well-developed leasing market. One would expect that the time required to convert bullion into producer inventory is short, relative to other commodities which may be less liquidand less homogenous than gold and may require longer time scales to extract and be convertedinto usable producer inventory, making them more vulnerable to cyclical price volatility. Of course, because of the variability of demand, the price responsiveness of each commodity willdepend in part on precautionary inventory holding.The fundamental differences between gold and other financial assets and commodities give riseto the following “hard line” hypothesis: the impact of cyclical demand using as proxies GDP,inflation, nominal and real interest rates, and the term structure of interest rates on returns ongold, is negligible, in contrast to the impact of cyclical demand on other commodities andfinancial assets.

Using the gold price and US macroeconomic and financial market quarterly datafrom January 1975 to December 2001, the following conclusions may be drawn

:•There is no statistically significant correlation between returns on gold and changes inmacroeconomic variables, such as GDP, inflation and interest rates; whereas returns on other financial assets, such as the Dow Jones Industrial Average, Standard & Poor’s 500 index and10-year government bonds, are highly correlated with changes in macroeconomic variables.•Macroeconomic variables have a much stronger impact on other commodities (such asaluminum, oil and zinc) than they do on gold.•Returns on gold are less correlated with equity and bond indices than are returns on other commodities.

Global Scenario

Demand

Demand for gold is widely spread around the world. East Asia, the Indian sub-continent and theMiddle East accounted for 72% of world demand in 2007. 55% of demand is attributable to justfive countries - India, Italy, Turkey, USA and China, each market driven by a different set of socio-economic and cultural factors. Rapid demographic and other socio-economic changes inmany of the key consuming nations are also likely to produce new patterns of demand.This buying is likely to be centered in those countries where the investment element of the jewellery sector is strongest. The constraints surrounding mine output are unlikely to ease, andin fact, have the potential to worsen as credit conditions continue to cause problems for someminers and explorers. Furthermore, net selling by the central bank sector should remain atrelatively low levels. However, as we saw in Q4, much will depend on the direction of the gold price and the scrap response. Continued high levels of the gold price could see scrap levelsincrease further

Table: Identifiable Gold Demand (tones)