GMO

White PaPer
January 2012

Emerging Thoughts:
Emerging Consumers Drive Gold Prices: Who Knew?
Amit Bhartia and Matt Seto

onventional wisdom has it wrong. The prevailing view is that the rapid rise of gold prices over the past 10 years has been caused by monetary authorities in the developed world debasing their currencies. By this logic, investors in the developed world have hedged debasement risk by pouring money into gold, both in the form of direct purchases and via ETFs. We believe that gold is an emerging markets asset as much as it is a bet against the Federal Reserve, and that much of the rise in gold prices has been driven by purchases by emerging consumers, who are driven primarily by financial repression. The traditional framework used to analyze gold starts with the assumption that gold is the ultimate store of value. Along that line, if faith in paper currencies wanes, the price of gold should rise. Consequently, gold prices should be highly correlated to inflation. The traditional barometer for inflation and weak central banks, and thus gold, is U.S. inflation. This line of reasoning does provide some insight. Changes in U.S. inflation do explain gold price movements until 2000. Through the 70s, 80s, and 90s, changes in the gold price were matched by changes in the inflation rate.

Exhibit 1 Changes in Gold Price/U.S. Inflation Rate

1600 1400 1200 1000 800 600 400 200 0 1974 Gold CPI Expected Inflation 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1978 1982 1986 1990 1994 1998 2002 2006 2010 -5%
Source: Bloomberg

Nonetheless, we believe conventional wisdom is naive. It certainly fails to explain the last 10+ years, during which gold prices climbed from $300/oz. in 1999 to the current $1,700 mark, while actual inflation and expected inflation remained very well-behaved, staying between 0% and 5% during the same period. We think the missing factor is emerging markets consumption.

Gold purchases over the past 10 years have been derived increasingly from emerging markets, especially emerging Asian countries (with India, China, and Vietnam accounting for the bulk of the increase in demand). Whereas in 1999, emerging Asia accounted for only 39% of global gold demand, by 2010 this figure had reached 57% and has increased since then. Exhibit 2 illustrates emerging Asias increasing influence: from 1999 to 2010 its share of global gold demand increased from 39% to 57% by 2010 and is concomitant with the rapid rise in gold prices.
Exhibit 2 Emerging Asias Share of Global Gold Demand (1999-2010)
$1,400 $1,200 $1,000 $800 45% $600 $400 $200 $0 1999 40% 35% 30% Avg. Gold Price Emerging Asia as % of Global Demand 55% 50% 60%

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: GMO, GFMS Ltd., World Gold Council, Bloomberg

In fact, as Exhibit 3 shows, in dollar terms, emerging Asian purchases of gold have risen from about $10 billion in 1999 to $70 billion in 2010.
Exhibit 3 Emerging Asias Rising Gold Purchases
$80 $70 $60 $50 $40 $30 $20 $10 $0 1999 Emerging Asia Gold Purchased in US$ (bn)

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Source: GFMS Ltd., World Gold Council, Bloomberg

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Emerging Consumers Drive Gold Prices January 2012

Exhibit 4 shows aggregate demand of gold from 2000 to 2010 based on data from the World Gold Council. A total of 29,342 tons of gold were purchased for both investment and jewelry. A number of interesting observations can be drawn from the data: Developed market purchases of gold bars and jewelry accounted for 7,200 tons, or 25%. Despite all of the attention in the media, ETFs accounted for only 2,200 tons, less than 7.5% of the total. Central banks were net sellers of 3,300 tons, even as the Chinese and Russian central banks purchased 1,050 tons. Retail purchases from emerging markets totaled over 23,200 tons, a staggering 79% of total demand, far and away the primary demand component over this period China and India alone combined for a total of 9,000 tons, a figure that is more than the developed world as a whole and four times aggregate ETF demand.
Exhibit 4 Aggregate Gold Demand: 2000-2010
All Other Central Banks 25,000 20,000 15,000 10,000 5,000 0 -5,000 China & Russia Central Bank Emerging ex Asia Emerging Asia USA Japan Europe

Developed Markets Consumer

Emerging Markets Consumer

ETFs

Central Banks

Source: GFMS Ltd., World Gold Council

The data show that the bets against the Federal Reserve, at least in the form of ETF purchases over the past decade, were a relatively small part of the total demand. Instead, the really big bets were of a different flavor and originated almost entirely in emerging markets. We believe the interplay between high growth in household savings in emerging markets and financial repression fuelled this emerging markets gold demand. Because of capital controls that severely restrict money outflows, Chinese and Indian residents are essentially forced to either deposit their savings in a bank or invest in local equities. Governments regulate deposit rates, forcing negative real rates. Moreover, local equity markets are often incomplete. The recent dismal performance of these equity markets has not been encouraging either. Gold jewelry and gold bars, along with real estate, are the most prominent among the few alternatives.

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Emerging Consumers Drive Gold Prices January 2012

Coupled with this financial repression, savings in emerging markets rose dramatically in both relative and absolute terms between 2000 and 2010. In 2000, emerging markets accounted for roughly 25% of global GDP. By 2010 this figure reached 40%. Domestic savings in China rose from a 41% average in the 90s to 47% in the 2000s while Indias savings rate rose from 23% to 29%. Consequently, combined gross savings in China and India increased from $557 billion in 2000 to $3.4 trillion in 2010. Essentially, there was an enormous increase of money available to invest and, given the lack of good alternatives, gold was a preferred choice. The point is that the main driver for golds dramatic rise has been the emerging markets consumer. This is not to say that the conventional wisdom drivers for gold are not relevant. We believe they are. However, we believe they have not been material for the past 10 years. The implications for golds outlook are both negative and positive. On one hand, gold prices may be at risk if emerging market economies slow down or, worse, experience a hard landing. Its estimated that Indian households currently own 18,000 tons of gold, the equivalent of seven or eight years worth of global demand. If India were to experience a significant slowdown, some of this gold may go to market, although Indians have historically held onto their gold in bad times. Even in the scenario that emerging market economies maintain their momentum, gold would be negatively impacted if financial repression eases and India and China loosen capital controls and allow assets to flow outside the country. On the other hand, this analysis indicates that conventional wisdom demand is far from saturated. Central banks have been net sellers of gold and it remains a small percent of overall reserves. Similarly, gold as a percentage of liquid portfolios in the developed markets remains untapped. These latter two reasons indicate that gold prices may very well experience another leg up. Our intent is not to make predictions about the price of gold, but to create awareness that emerging markets represent a significant factor in how gold is being, as well as will be, priced in the future.

Mr. Bhartia is engaged in portfolio management for the GMO Emerging Markets strategies. Prior to joining GMO in 1995, he worked as an investment advisor in India. Mr. Bhartia earned a Bachelor of Engineering at the University of Bombay and an M.B.A. at the Institute for Technology and Management in Bombay. He is a CFA charterholder. Mr. Seto is engaged in research for the GMO emerging market equities products. Prior to joining GMO full time in 2008, he was a vice-president in the global markets group at HSBC. Mr. Seto earned his BA in economics from the University of Michigan and an MBA from Columbia University.
Disclaimer: The views expressed herein are those of Amit Bhartia and Matt Seto and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Copyright 2012 by GMO LLC. All rights reserved.

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Emerging Consumers Drive Gold Prices January 2012