Distortions in markets during gold rush

Posted On Tuesday, Oct 29, 2013


Battling the surging current account deficit problem, the policy makers found gold an easy target. Gold being “apolitical” in the Indian context, it was easy to restrict gold imports, the second biggest imported element after crude oil. When people made finance ministers plea of not buying gold for one year to go unheard, the result was surging import duties and import restrictions. Rather, a quasi ban on imports was introduced when imports were tied to exports. Since we do not have enough exports to support our consumption needs, we are not left with enough supplies and whatever available is going for significant premiums with buyers being forced to pay higher for the gold they require.

The Price Impact

Consumers were already reeling under the pressure of import duty currently pegged at 10%, now the premiums on physical supplies which have been inching closer to $80-100 per ounce which corresponds to an addition of 5-7% are straining buyers further. So buyers have to pay 15-17% higher than international prices (converted in rupees) when they buy in the domestic markets. This has resulted in a completely distorted market which could get worse as festive purchases gather steam.

The anomaly

Gold ETFs too being backed by physical gold are traded at premiums close to one’s prevailing in the domestic market. However, there appears an anomaly in the value of Gold ETFs NAV and its traded price. Gold ETFs NAV is determined using a formula prescribed by SEBI for valuation of gold. Its components include the London AM Fix Price (for International gold prices) and the RBI reference rate (for converting the dollar prices to rupees) plus the levies, duties and taxes. This is how the gold held by the Gold ETF is valued. If you observe, the formula does not allow for factoring the local market premium / discounts prevailing in the domestic market. Whereas the trading prices would naturally involve the premiums reflected in the local physical market as gold ETFs are backed with physical gold and would in a virtual sense be akin to buying / selling physical gold. Therefore, in such times there would be a difference between the NAV of the Gold ETF and its trading price largely reflecting the premiums in the local gold market.

The other aspect is with the gold savings funds. These funds in turn invest in the gold ETFs and are valued at the traded prices and therefore reflect the premiums prevailing in the domestic market. Therefore, if an investor compares the returns of the Gold ETF which is usually calculated by change in NAV and that of the Gold savings Fund, there would be a huge difference. This is because the former does not include premiums whereas the latter does. Investors should not confuse them on account of this return differential, it’s just a perceived anomaly and nothing beyond that. The gold ETF investor would likely have similar returns if calculated using the trading price. The two value of the same fund just creates an illusionary confusion but in reality is nonexistent. These anomalies would get corrected after the market distortions wane away.

Shooting the messenger

Gold is not the problem but is really a symptom. Trends in gold consumption and prices tells us too many things about the macroeconomic environment prevailing. Increased gold consumption is a signal of imprudent policies prevailing in a country driving people towards gold consumption. It’s not only the social and cultural affection towards gold; this love affair with gold also has strong economic underpinnings.

It’s a wishful thinking that the dream of the seer Shoban Sarkar indeed comes true which could help the Indian Sarkar towards improving government finances and would likely bring much needed relief to gold buyers who are currently reeling under pressure of high import duty and surging premiums and still struggling to obtain their pie of the yellow metal.

Data Source: Bloomberg, World Gold Council

Statutory Details and Risk Factors:
The views expressed here in this article are for general information and reading purpose only. The views expressed here do not constitute any guidelines or recommendation on any course of action to be followed by the reader. The views are based on the publicly available information, internally developed data and other sources believed to be reliable. The views are meant for general reading purpose only and are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the readers. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and opinions given fair and reasonable. Recipients of this information should rely on information/data arising out of their own investigations. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments. None of The Sponsor, The Investment Manager, The Trustee, their respective directors, employees, affiliates or representatives shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the information contained in this document. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.

Above article is authored by Quantum.

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