In Gold We Trust! - Part 1

An average Indian’s, love for the ‘Yellow Beauty’ is well known for ages. In the monetary system evolution, Gold & other precious metals – e.g. Silver – assumed great importance as the medium of exchange after the end of Barter system.

For the past 4 centuries it has been proven that Gold is one of the very few assets whose purchasing power has remained stable. A research by World Gold Council clearly shows that Gold is the only medium of exchange that has maintained purchasing power as compared to the major currencies of the world. All major currencies (USD, Sterling, Euro, Yen etc.) have in fact gone down in their purchasing power. (Image Source: http://www.gold.org/)

I did a quick scan of Indian inflation & Gold price movements in past 37 years. Gold rose around 70 times since 1970 in Rupee terms (Indian Bullion Mkt), whereas inflation in India – after adjusting for WPI base year shifts – has risen between 16 & 19 times during the same period.

So does this mean we have to invest heavily in Gold? Absolutely not!

This data in isolation of other information may mislead an investor to have a Gold dominated investment portfolio. The huge gap seemed lopsided to me. In earlier years, Gold imports were strictly governed in India. The Gold price differential during years 1970 to 1992 between Indian domestic market & world market was very significant (e.g. in 1970 the difference was 100%!). Obviously this lead to parallel Gold market whose movement remained unreported & hence unmeasured. If one looks at the domestic price movement & inflation since 1992 (the post liberalization era) then slightly more realistic picture emerges. Price index has gone up by 281% whereas Gold price has moved by 305%.

Conclusion - Gold still remains the one major commodity whose value has either kept up with inflation or beaten it!

Does Gold ALWAYS beat inflation?
While it is a general belief that Gold has proven to be consistent hedge against inflation, there have been a few remarkable milestones in recent history that point out that there are some other factors in play too. For instance in 1980, Gold price went beyond $850/oz on the back of Russian attack on Afghanistan. The US economy was witnessing unprecedented inflation rate of close to 17%! USA Fed head Paul Volker in 1980 raised domestic interest rates to 20%. That probably helped to calm down 17% inflation levels in next several months. However it is believed to have dealt a blow to Gold prices. How? – high interest rates rewarded more cash balances & probably killed speculative activities in Gold trading.

Probable Conclusion – Inflation needs to be more than interest rate for Gold to attract more returns than cash.

Today's situation
Does one really anticipate USA Fed today to take U turn & drastically increase Dollar interest rates? USD itself may lose it’s poster-boy image in International monetary system. In the short term, chaos that may be created, if this really happened that is, Gold will certainly hold more than equal status.

I interviewed few colleagues & ex-colleagues from countries that recently witnessed hyper inflation & economic crises – Malaysia & Thailand (1997) & Russia (1998). The interviews unsurprisingly pointed out the undisputed role of Gold in such economic disasters.

In the current global economic situation – rapidly rising oil & food prices, looming recession on the biggest economy of the world (USA), plummeting stock markets – an average investor with average risk appetite is recommended to play defensive. Every such investor needs to look for locking the value of one’s wealth & probably increasing the same at a rate which is at least equal to rapid inflation rate if not more. Obviously one would not recommend hoarding US Dollars for wealth retention. While all the world economies will try shoring up US Dollar valuations to protect their intertwined interests, I would definitely recommend hedging against sharp USD depreciation by investing in Gold.

In the next post, I will talk about various forms of Gold investment & recommended exposure to Gold in your portfolio (considering an average risk appetite).

In the coming weeks...

1) In Gold we trust
2) Real estate options
3) KB - Monetary Systems evolution, present & future
4) Comparative analysis of a few well known investment options
5) Repay loans v/s Invest elsewhere

*KB = Knowledge Base

Every weekend I will handle at least one topic. This is a generic list & does not necessarily represent the order in which posts will be published. I may have to insert any other topic(s) if the situation demands so. I will keep updating this list as we go along.

Current Affair – Rising Inflation

Simply put, Inflation is rise in prices of commodity basket relevant to a base year. Conversely, it also represents change (usually downward) in buying power of a single monetary unit.

Method for inflation calculation
Most developed nations calculate inflation based on Consumer Price Index (CPI). India has adopted Wholesale Price Index (WPI). WPI is calculated on a weekly basis with a lag of 2 weeks. It is the index (base year 1993-94) of weighted average of prices of commodities.

In India, Office of the Economic Adviser (OEA) - attached to Ministry of Commerce & Industry – is responsible for Compilation and publication of the weekly WPI.

Why is inflation rising?
Qualitatively economists generally are blaming the global inflationary trend on 2 basic reasons – rise in fuel prices & rise in food prices.

Quantitatively here is the trend of inflation in current calendar year. Now let's to look under the covers for constituents of WPI in India. WPI is calculated based on 3 commodity groups:

1) Primary Commodities
2) Fuel, Power, Light & Lubricant
3) Manufactured Products

Each commodity in these groups & in-turn the groups themselves have weights assigned. And now the all too revealing WPI movement across the commodity groups the same period! (Chart 2)

If one closely looks at the various commodity movement in chart 2, then the correlation between recent spurt in “Fuel, Power, Light & Lubricants” group & the one in Inflation % is quite obvious! So in short the figures corroborate (to a large extent) the qualitative information. A little more drill-down into data shows aggressive movements in past 1-2 months in Mineral Oils, LPG, Petrol, Aviation Turbine Fuel etc.

Macro economic strategies of various countries
While India has placed more importance on arresting inflation; the USA seems to be going after “Growth” issue. For India, growth is not a challenge in the present situation while USA seems to have put Inflation management secondary to solving looming recession. The macro measures these two countries are taking are representative of what issues are more important to them. USA is slashing interest rates whereas India is raising those! This clearly indicates that USA Fed wants to encourage speding (by improving money supply) so that they tackle the “Growth” problem. However for India, restricting the money supply (to arrest inflation) is the way to go by increasing the cost of borrowing.

It is also said that rising crude prices are in the best interest of not only the oil producing nations but also of USA (apart from it's role in oil production). The simple logic provided is that bulk of oil trades happen in US Dollars. More the price per barrel in USD, more the demand for Dollars in international market. This helps create one of the many outlets for absorbing the rising Dollar supply. While to some extent this may save falling Dollar, it definitely adds to global inflation!

Well, this is just a scene when we look at 2 national economies. Once we start looking at all major nations, the situation becomes quite complex. One would wonder if there is any way out! The answer is not that simple. Probably one of the initial ways is to look at world as one whole economy rather than individual nations. This role being already played collectively by WB, IMF & UN, it is interesting to see how far the major national economies of the world stretch the current global monetary system. The more conflicting the national strategies, the faster we accelerate shift from current monetary system. More about the monetary system(s) in subsequent posts.

Finance Capsules(c) - Rationale

'Is money important to you?', if the answer is a resounding "No!", then you are probably wasting your time reading this blog. However if the answer is "Yes" or "May be", then read on.

If you are still with me, then in past you must have dealt with multiple questions surrounding money - 'How do I make more money through legal sources?', 'How can I achieve financial independence?', 'How can I grow my money?', better still - 'How can I effectively manage whatever money/ wealth I have?’ & many such relevant but apparently simple topics. For those who have figured out the answers, this is not the blog to be.

While interacting with those who are still trying to figure it out, I normally come across many conversations. There are multiple common themes that run through these conversations. One of the more prominent ones is – ‘I know that I don’t know enough, however I don’t know where to start. There is sea of knowledge out there to cover in my entire lifetime!’

This blog is an attempt to share whatever limited knowledge I have about generic Finance. The goal of this blog is twofold –
1) Share information, knowledge & analysis of current affairs, while clarifying some basics.
2) Do this in concise manner. I will attempt to ensure that none of my postings are beyond 800 words +/- few. Believe me – this is a tough challenge for a person who likes to write loads of stuff :-). That’s why the blog title – “Finance Capsules ©”.

To start with, I will divide my posts in 2 categories – Current Affairs & Finance Concepts. As the names suggest, while the posts in first category will provide analysis of present happenings around us, the second category will focus on clarifying finance at conceptual level. You may find a few cross references from one category to the other, however I will try to keep those to-the-point without disturbing the main theme.

The usual disclaimer applies here too - This blog does not provide silver bullet for your financial situations. It is merely a tool & knowledge base that you can use to make your own financial decisions. Readers' discretion advised!

So shall we begin? Let’s go!