A bad monsoon could queer the pitch for gold

We Indians just love gold, don’t we?

As per the World Gold Council (www.gold.org), a whopping 4004.80 tonne of the yellow metal was imported by India between 2004 and 2009. What’s more, together, Indians and Japanese account for a major share of worldwide demand for gold at the individual level, though there’s China hot on the heels.

Recent trends, however, indicate a declining appetite in the country, the marriage season demand notwithstanding. The assumption not so long ago that gold prices will continue to rise now seems out of place.

For every bullish trigger, there is a contra trigger.

Here are a few aspects investors and traders alike would be the wiser for not losing sight of.

The agricultural connection: Demand for gold is quite robust in the heartland of the country.

Given a good crop, purchases by affluent agriculturists can put urban buyers to shame. Agricultural income is tax-free. Also, literacy levels in the rural reaches are low and the average Indian farmer does not understand and/ or is unaware of the other avenues he could deploy his investment surplus in.

Bank penetration is lower than optimal levels and is only picking up gradually; where bank branches do exist, farmers prefer to use them as money lenders rather than for depositing their cash and getting an electronic statement for their money. They prefer to invest in gold, which they can touch, see, feel and are comfortable with.

A poor monsoon could, however, dampen the rural demand for this precious metal.

Overseas market players and analysts keenly monitor these aspects of our gold markets. The poor monsoons in 2009 are partly to be blamed for the sluggish gold prices in 2010.

The ‘second hand’ market: If a farmer prefers to save money in physical gold, he also uses this as collateral to raise funds from banks, private financiers and pawn brokers.

The last two lenders are expensive and quite undesirable (from the borrowers’ point of view) where debt servicing is concerned. Banks and corporates charge about 12% per annum on loans against gold and lend anything between Rs 10 lakh and Rs 1 crore. Companies like Muthoot Finance do not put a cap on borrowing. Where banks are absent, the borrowing farmer has no real option but to borrow from these private lenders and pawn brokers.

The culture of pledging gold is fast spreading to the urban population as well, if the offers of public and private sector banks to lend money against gold jewellery are any indication.

Competitive forces have ensured that the buffer (haircut factor) retained by the lender is shrinking. The norm in the industry is between 70% and 85% of the market value, though private lenders are known to go higher.

It should also be understood that majority of Indian jewellery is made by family appointed goldsmiths thro-ugh generations and don’t offer hallmarking benefits, leading to lower realisation at the time of resale. The risk to a lender is therefore higher.

Since private financiers and pawn brokers charge exhorbitant rates of interest, it is critical that gold prices remain buoyant or the borrower actually stands to benefit if he defaults and forfeits the gold.

The recurring interest costs add to the original cost of acquisition of the pawned jewellery, and the borrower is interested in redeeming his pledged gold if and only if the ruling prices are higher than his purchase cost plus interest accrued. The lenders understand this and are getting increasingly quick on the draw to liquidate the collateral if they sense a threat of forfeiture.

In my opinion, this “second hand” market for gold (dynamics change year to year) is sizeably bigger this year than the “first hand market” as high bullion prices have deterred buyers and encouraged borrowers to avail of loans to tide over a liquidity crunch, especially in the rural areas.

Should the price of gold decline below the Rs 16,000 mark in the near term or even remain static over the medium term, there is an increasing risk of this “second hand” pledged gold being offered in the street. That will have a multiplier effect and exert a downward pressure on prices.

The 2010 monsoon will be a critical factor for not only the economic outlook for the country but also the prospects of this “second hand” market. Bullion traders can ignore this aspect entirely at their own peril.

Technical outlook: Note that the price is precariously close to its 200-day simple moving average and should not be violated on a consistent closing basis if the uptrend is to be sustained.

A decline below the Rs 16,000 per 10 gm level is unlikely to be a happy situation for the bulls. In case the bears manage to keep the prices subdued below the Rs 15,750-16,000 band, there is a possibility of the yellow metal declining to or below the Rs 15,000 mark in the calendar year.

On the flip side, the price must rally past the Rs 17,000-17,250 band if bullishness is to remain intact.

Watch the coming weeks keenly, especially the Met forecasts of monsoons.

The analyst is the author of A Traders Guide to Indian Commodity Markets and invites feedback at vijay@BSPLindia.com.