Gold buyers and investors in India are a little distraught these days. Last week, gold prices hit a five-month low and market commentary on the yellow metal has not been very encouraging. At their current levels, gold prices are down nearly 10 percent from their yearly high in the international market.
In contrast equity markets seem to be on steroids and continue to climb higher. The benchmark NSE Nifty 50 index made a fresh life-time high in the last week of November and most equity analysts expect it to climb higher in the coming weeks.
This must be discomforting for gold buyers for whom gold is a hedge against instability and uncertainty in the broader economy and other assets markets.
But it would be too early for gold buyers in Indian to lose faith in the yellow metal. The economic uncertainty that fuelled the rally in gold in the first half of the current calendar year seems to have eased for the time being.
Even if we are able to control the virus through medical advances such as vaccines and a general build-up in herd immunity, the pandemic will leave us with a huge liability that will weigh on the economy for years to come. This will increase economic uncertainty going forward and diminish it as the rally in Indian equity market may suggest.
It could have an adverse impact on rupee-dollar exchange rate going forward. And historically gold has been a better hedge than equity against domestic inflation as well as currency depreciation.
In the last ten years, gold prices are up 42 percent in the US dollar terms, rising at an annualised rate of 3.5 percent. In the same period, gold prices are up 135 percent in rupee terms, appreciating at an annualised rate of 8.9 percent. The additional 530 basis points annualised return for rupee investors matches the 5 percent annualised depreciation in the value of rupee against the US dollar during the period.
In comparison, Nifty 50 has appreciation at an annualised rate of 6.7 percent during the period, providing only a partial protection against inflation and currency depreciation. (See the chart below).
This hedging property of gold could prove even more important in the months to come. The inflation pressure has begun to build-up in the Indian economy after years of price stability.
Many experts believe the recent rise in inflation to be transitory but I beg to disagree with this benign view. Fiscal and monetary policy has a big influence on inflation in the medium to long-term. And both the government of India and the Reserve Bank of India are following inflationary policies.
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According to the International Monetary Fund (IMF), the combined debt of the central and the state governments is likely to reach an all-time high of 90 percent of India’s gross domestic product (GDP) by the end of March this year.
The inflation has also got a boost from a loose monetary policy being followed by the Reserve Bank of India. For example, RBI balance sheet was up by nearly 30 per cent in FY20 as it added nearly Rs 12 lakh crore to its balance sheet last fiscal.
This has been worsened by the anti-trade stance of the government under the self-reliance or Aatmanirbhar economic policy. Imports are being discouraged through hike in customs duty and erecting physical barriers to imports through delay in customs clearances. The end result has been a general shortage of goods in the market leading to price rise.
Price inflation is the most visible in basic and intermediate goods such as tyres, metals, glass and bulk chemicals among others. This coupled with high taxes on fuel will translate into higher production cost across the industry fuelling a cycle of higher prices.
Not surprisingly, consumer price index or inflation continue to climb.
The rise in prices came despite a decline in consumer’s purchasing power due to job losses and salary cuts due to the pandemic. Imagine the price situation after a year when many consumers may see a partial if not the full restoration of loss in income.
Higher inflation has so far spared the foreign exchange market but it’s a matter of time. If inflation stays higher for a few more months, it may start putting pressure on the rupee leading to a depreciation in its value against major currencies such as the US dollar and Euro.
For example, the rupee is down 35 percent against the US dollar in the last ten years against a 45 percent rise in price index during the period. The gap is due to the influence of capital flows that hint at a relative over valuation of the rupee. (See the chart below).
In currency market adjustments happen with a lag but when they happen it can be very sudden and savage. This happened to the Turkish Lira when it halved in value in the 2018 in the space of a few months. Similarly, Pakistani rupee fell by nearly 50 per cent in the first half of 2018.
India may be better placed than these countries but it is best to stay invested in gold to ensure your portfolio from the macroeconomic headwinds that lie ahead.
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).