The answer to this question is not entirely straightforward as investors in gold take many forms. Gold’s history goes right back to ancient times when its beauty and nobility (in chemical terms, that is its resistance to oxidation) and – in relative terms at least – its accessibility on surface in parts of Africa and Nubia, meant that it became a natural mechanism for transactions. And as we evolved our currency systems, its anonymity made it the currency of choice for many.
Asset of choice
So we have different concepts of “safe haven” here. Its history as a hedge against inflation is effectively self-fulfilling and the only reason why pundits have been claiming over the past two decades that it has lost its role as an inflation hedge is because, in the western hemisphere at least, there’s been no inflation against which to hedge. In parts of Asia, where there have been occasional recent inflationary pressures or expectations, allied to depreciating currencies, gold has remained an asset of choice to combat both these forces – which of course are themselves intertwined.
Consider these two charts. What they show is nominal gold prices against the annualized U.S. Consumer Price Index (CPI) and gold rebased to March 1968 using the U.S. CPI. The massive surge in price to $850 over 1976-January 1980 on the back of the oil crisis, the invasion of Afghanistan and the Iranian hostage issue (and the Hunt Brothers’ attempt to corner silver) was the subject of much fanfare. Less heralded, however, was the run up to record nominal levels from 2008 to mid-2011, in a distinctly non-inflationary but very financially nervous environment. So these two bull runs reflect different tailwinds for gold; inflation and geopolitical risk on one hand, and financial and geopolitical risk on the other.
Gold vs. annualized U.S. Consumer Price Index (CPI)
Real gold price, rebased to March 1968
Price vs. value
This is where we come to an important distinction – between “price” and “value.” Gold’s price is tangible, measurable in any currency you choose and subject to market forces. Gold’s value is far more conceptual. It is reflected in its anonymity and portability for those fleeing from risk or danger, while its very low or negative correlation with virtually all other asset classes, as well as its role as an inflation hedge, makes it a valuable component of a portfolio as it expands the efficient frontier (higher reward for same risk and vice versa). This is why if an investor is looking to spread risk across his portfolio, it doesn’t matter what price they pay for the gold because over time its contrarian spirit will mitigate his risks. If they are looking for capital appreciation, of course, the argument is very different.
Governments turn to gold
The fact that gold is not a fiat currency (government-declared legal tender that is not backed by a physical commodity) also means that it is of value to the banking system, notably the official sector.
One of the best examples of this was the case of South Korea during the Asian financial crisis that started in 1997. It had started with the collapse of the Thai baht, but contagion meant that the problem quickly spread, with South Korea’s debt-to-GDP ratio more than doubling and the level of the currency halving. The IMF stepped in to help, but gold also played a key role.
The government went to the populace offering interest-bearing won-denominated bonds in return for privately-held gold, because the won wasn’t wanted in the forex market and the government was at risk of default. In the end, more than 300 tonnes of scrap gold came out (some of this would have been distress sales, but most was in response to the government’s plea), which would have been high-purity jewelry that the government was then able to mobilize into bullion, sell in the market, raise dollars, pay its interest bill and thus avoid defaulting on its debt. This was a phenomenal response – Korean scrap return had previously varied between six and twelve tonnes per annum!
When it comes to currency — investors, governments, ordinary citizens and even criminals want something they can count on.
Gold attractive to smugglers, too
The fact that gold is an anonymous, portable currency that holds its value over time and is acceptable virtually everywhere means that it has another use beloved of an entrepreneurial minority – smuggling and money laundering. Smuggling has been endemic in the gold market for as long as there have been regulations. India is a classic case in point; smuggling has always been a headache for the government there, but in 2013 official imports came under fire also as the government looked for ways to reduce its trade deficit. Oil is the largest contributor to the deficit but gold is second at more than 30% of total, and in 2013 the government started imposing a series of restrictions on import levels and imposed other mechanisms such as the 80:20 rule (importers to ring-fence 20% of their imports for re-export after adding value – usually simple jewelry). Result: increased smuggling and little change in either jewelry or bar investment locally. The picture changed in 2014 and while the reduction in availability through official channels was partly responsible, other reasons also prevailed, such as weaker investor price expectation, a crackdown on corruption (QED) and a liquidity crunch in the first half-year ahead of the general election.
India is not the only country involved in what is euphemistically known as the parallel market; part of the fall in Chinese gold demand last year was due also to a salvo against corruption, including “gifting”, of which gold has formed a large part. Smuggling is also rife in many other parts of the world and is unlikely ever to be stamped out.
When it comes to currency — investors, governments, ordinary citizens and even criminals want something they can count on. That’s why in times of financial trouble, in times of uncertainty and when investors are feeling risk averse, gold will always be a go-to.
This is the third installment of a new Answers On series on gold. Check out our earlier posts on how the gold market has changed over the past half century and whether gold jewelry is for adornment or investment (spoiler: it’s both!).
You can also get much more information, anecdotes and statistics on the gold market, past and present, by downloading a complimentary copy of the 50th Anniversary GFMS Gold Survey.