Is Gold really a store of value?

What makes an asset a store of value? Is it the lack of supply or is its perceived value in the minds of the people. An ideal store of value is an asset which is limited in supply and it is expected to be so at any given point of time especially during times of crisis or afterwards. Lets write down the key features of such an asset,

1. It is limited in supply and its supply is not distorted by market dynamics

2. It is easily fungible and it is recognized across different markets

3. Storage costs are very low and it is easily transportable (not counting security costs)

4. Quality is easily verifiable and defined standards for its quality

5. Ease in buying and selling and has a liquid market (they both are different even though one does not exist without the other)

Now that we have listed down the qualities, lets see if gold is a suitable candidate in the current scenario,

Point 1 is the toughest one, which we tackle in the later part of the blog. Gold strikes "gold" when it comes to points 2,3 .4 and 5. It is an ideal candidate and it is compact and very easy to hold/transport. With increasing technology and growth of the ETF market, the liquidity of the market has only increased. It is very easy to buy gold these days, especially if it is "electronic gold", you just need a demat account to hold it.

Coming back to Point 1, lets have a look at the demand and supply statistics of Gold. The overview of the sector as stated in the Gold Council report for 1Q 2011 is,

" Gold Demand in the first quarter of 2011 totalled 981.3 tonnes, worth US $ 43.7 tonnes. Much of the 100-tonne increase in demand was due to strong growth in the investment sector. We believe suitable conditions remain in place to ensure that investment demand will maintain its sold growth path in coming quarters"

Demand for gold has been quite steady over the last 2-3 quarters at around 1000 tonnes. Important to note that demand fell after the financial crisis primarily driven by the fall in demand for jewellery. This loss of demand for jewellery is as expected. The total demand of gold for investment purposes has been steadily increasing over the last few quarters. The demand for gold bars had peaked during the financial crisis and has been on an increasing trend since then. Gold holdings of ETF's also has been increasing. It is important to distinguish this demand from demand for jewellery, jewellery demand is more consumption in nature rather than investment nature. The only other usage of gold is in the technology sector, which has seen steady demand over the last few quarters.

Lets have a look at the supply side, the total supply from mines has been constant at around 600 tonnes per quarter. The other main supply source is recycling of gold recovered from old fabricated products. One has to note the increase in supply of recycled gold after the financial crisis. This coincided with the rise of gold prices after the financial crisis. Over the last few quarter the supply has been around 1000 tonnes per quarter. This supply matches with the demand. But with increasing demand for gold as an investment, price rise can only be expected as the short fall has to be met by recycled gold.

Now lets envisage a scenario where we are currently facing a sudden economic/financial crisis, could be brought about by european crisis. Now as it has been stated that gold is a store of value, the demand for gold would shoot up, with many people buying gold to store their wealth. Now considering that the supply is limited, the price would shoot up. Till now the crisis proceeds along expected lines. Now once the initial fears become subdued, the supply of gold would shoot up...the supply would not only be from traditional sources but also from all the sources who have bought gold for investment purposes. People would liquidate their ETF holdings to make profits from the high prices and invest the proceeds in other assets to make use of low prices of other asset prices. This would put pressure on the price of gold. So it is it an asset which can store the value??

My view is that the current rise in demand for gold as an investment vehicle has distorted the supply demand dynamics. The price would be driven by investment rather than any other purposes, thus making its value dependent rather than independent. Point 1 has been distorted.

This is similar story of what happened to land as a store of value. Prior to 2008, land has always been viewed as an asset which never loses it value. But with the sudden increase in demand for land as an investment, distorted the value and demand supply mechanics. With a sudden supply coming up post the crisis, the value plummeted and the market became illiquid.