Bachelor Thesis. Drivers behind the Demand for Gold

Transcription

1 Bachelor Thesis University of Amsterdam Djao van Bueren Drivers behind the Demand for Gold Abstract Which factors drive the demand for gold? There are physical and investment side factors driving the demand for gold and thus its price. Physical demand follows the economic cycle and investment demand seems to do the contrary. The intrinsic value of gold comes from its physical applications not from its investment purposes. The increased investment demand, which we have seen over the last 6 years in combination with decreased physical demand, should be looked at carefully since this might indicate the start of a bubble in the gold price. 1

2 1. Introduction In the last 40 years we have seen tremendous economic growth, industries have grown bigger than ever and we all became richer than ever before. With this growth we have also seen the price of gold has rising to sky-high levels. During the Bretton Woods period, which ended in 1973, the price of gold was pecked at 35$ per ounce where it has now approached a level around 1500$ per ounce. Since the fall of the Bretton Wood system, the price of one ounce of gold has been rising ever since. Fluctuations occurred but roughly the price has only been increasing. During the recent financial crisis we have seen an enormous increase in the price of gold reaching levels of more than 1800$ per ounce. Gold has always been seen as a commodity which is save, so in uncertain times investors like to hold gold since this gives them less risk. But looking at the rate at which the price of gold has increased during the last 40 years, you could perhaps state that the gold gives the security of a solid investment with high levels of growth. So why do investors buy gold? What are the factors that determine the price of an ounce of gold? Such as every other traded good, the price of gold is determined by its supply and demand. Looking at the development of the price of gold, you may assume that the demand for gold has risen stronger than the supply of gold. In this research I will investigate how the different demand side factors determine the price of gold? I will use historical data to determine the relevant factors driving the gold price. Since the recent crises the price of gold has raised a lot, but why has this price increased so much? Is that just because of uncertainty or are industrial factors also playing a role? Some investors fear that the tremendous increase in the price of gold may indicate a new big bubble. Therefore it would be very important to research what factors lay underneath the price of gold. Since this could give a good insight in whether the recent level of the price of gold is a realistic one or whether it has been growing due to speculation. That is why I think this research is important and relevant. In my research I will use historical data to construct a model of relevant variables that can estimate the demand for gold. In this research I will focus on the demand side only, because the fluctuations in the supply of gold are relatively constant compared to the fluctuations in the demand for gold. 2

3 This research is organized as follows. In section two the existing literature is discussed. Part three explains the methods that will be used to construct the model. In part four the model is being presented and explained in more detail. Part five will conclude and do some suggestions for possible further research. 2. Literature review In considering the price fluctuations of gold both for the long run and for the short run it is important to understand that the price of gold is influenced by two sides. The commodity side where gold as a commodity and the speculation investment side where gold as an investment. Public and private gold hoards can have a big influence on the price of gold. Heavy fluctuations in these hoards might influence the ability to estimate the price of gold (Baker and van Tassel, 1985). Van Tassel (1973) also argued in his work, that the gold price is automatically stabilized which means that its price on the long run should be constant and can only fluctuate in the short run. Due to speculation the price of gold tends to rise, the industrial demand for gold will decrease and its price will then drop. If the price is low, industrial demand will push the price upwards. In the long run prices will depend on industrial and economic growth rates. In constructing a model that covers most relevant factors for changes in the price of gold Baker and van Tassel (1985) find five main variables. Since the price of gold is denominated in terms of dollars, the exchange rate of the dollar can influence the price of gold, because if the dollar depreciates assuming that the price of gold stays constant then that price denoted in dollars would have to increase. For this reason it is assumed that the price of gold is inversely related to the price of the dollar. Interest rate, because if the interest rate increases, the opportunity costs of holding assets and thus of holding gold will increase, so investors searching for a balanced portfolio will sell part of their gold and because of that its price will decrease. At the same time a higher US interest rate will also cause an increase in the price of the dollar and thus lower the price of gold. The inflation rate also influences the gold price, a rise of inflation cause a rise in the price of gold as well, because investors use gold as inflation protection. Inflation in the US will also lead to a depreciation of the dollar and hence a rise of the gold price. The price of commodities can also influence the price of gold because in producing some 3

4 commodities gold is being used, another point is that if demand for commodities overall decreases it is likely that the demand for gold will also decrease. Baker and van Tassel (1985) describe one more factor, which is speculative bubbles; this is a special case because speculative bubbles arise because of speculation by investors. For these investors gold doesn t have an intrinsic value, as is the case for industrial purposes. In history there have been speculative bubbles, investors driving up the price of gold without any economic underlying reason for this price rise. Speculative bubbles can occur in time of uncertainty, but it is very hard to measure when a bubble is emerging. Investors demanding gold doesn t necessarily mean that a bubble is emerging, investors can demand gold for various reasons. According to Baur and McDermott (2010) the demand for gold is influenced by three main categories: jewelry market, industrial & dental market and investment demand. The first two jewelry and industrial & dental demand are following the economic cycle, so in the downturn demand is low and in the upturn demand is high. The investment demand however is countercyclical so it runs in the opposite direction of the demand from jewelry and industrial & dental demand. This may in part explain why the price of gold is in general at a rising trend, because in economic good times jewelry and industrial & dental demand is high and in difficult economic times investment demand is low. Starr and Tran (2008) distinguish the same but they also add another factor, which is retail investment. A retail investment in gold consists of buying golden bars to produce coins medallions and other products like that. Countries and investors are using gold as a form of inflation protection. When investors or countries fear that their currency might suffer from inflation, which will affect their wealth, they tend to demand more gold as an inflation hedge (Baur and McDermott, 2010). When volatility is high investors try to protect their wealth by buying gold, since gold seems to be unaffected when stock prices drop, however this is only a short term measure when volatility drops investors sell their gold hoards (Baur and Lucey, 2010). The world s economy has been growing tremendously in the last decades. This increased economic growth resulted in higher levels of industrial production and higher levels of wealth, also in emerging countries. The higher levels of industrial production might be one of the reasons for an increased demand for gold, since gold is being used in a lot different industries. The largest part of industrial demand comes from the 4

5 electronics and IT sector. These industries use a lot of gold to produce all kinds of electronic chips and especially this market has grown a lot in recent decades. In general it has been seen that up to a certain point an increase in income will result in an increase in the demand for gold as well. In some of the emerging countries like India (which is the world s largest consumer of gold), Pakistan and China, gold has a very traditional role, as a symbol of wealth and status, so since these countries have undergone a huge economic development we have also seen an increase in their demand for gold (Starr and Tran, 2008). The difference however between emerging countries and emerged countries is that the role of gold as a storage of wealth is more used by emerging than by emerged countries. This can partly be explained by the fact that emerging countries have a less developed financial system and thus little options for investing their wealth in all kinds of assets. Some studies also take the price of gold as a determinant of the demand for gold. In this research however this is not taken into account since I assumed that supply is relatively stable and because of that the demand side is the only driving force behind the price. In this research I will try to find out which variables influence the demand and thus the price of gold. The existing literature has different opinions about what drives the demand for gold. Some of the literature reviewed is 30 years old, so the links they found might not be valid anymore. This research contribution is that it combines the most relevant variables in one research and that this research checks whether or not links found in the past are still valid. This has not been done yet so it is might be possible that this research will find very different outcomes than the existing literature did. 3. Methodology In this research I will construct a model that includes relevant factors for explaining the demand side for gold. To distinguish which factors are relevant and which are not, I will use historical data to check whether there is a correlation between the variable and the demand for gold. The model will initially contain all the factors described in the literature review, but since some of the literature has been written many years ago I 5

6 expect some different outcomes. I will not do a regression on the whole model since this would be too complicated for this kind of research, since a lot of different kinds of data would be involved. The model that I will try to investigate will be as follows: Demand for gold=jewelry demand+ industrial demand+ dental demand+ level of inflation+ GDP growth+ interest rate level+ commodity prices+ Investment speculation For each of the potential driving factors behind the price of gold I will compare the gold price levels over time with the figures of the certain variable. I will start with an inflation correction on the price of gold to find out whether the current price of gold is also in real terms the highest we have seen so far, since the price of gold is denominated in dollar terms I will use US inflation figures. This is a very important step because the corrected price of gold might be quite stable. After that I will focus on the other factors that might have an influence on the demand for gold. In the last 35 years we have seen periods of high inflation volatility; we can compare the movements of the gold price in these certain periods and check if there is a connection to the inflation rate. The level of industrial growth over the last 35 years can be compared with the growth rate of the gold price. I will use this method for all the variables discussed in the previous part and check whether there is a causal link between the variables movements of the gold price. At the end I will formulate the factors that have influenced previous price movements via the demand side. Since it will take an extended regression analyses to estimate what the exact influence is of each of the factors is on the demand for gold, I can t give any comments on that. Instead I will only try to find out what factors are significant and in which direction they influence the demand and thus the price of gold. 4. The model In this section I will try to find out which of the factors discussed earlier are significant and in which direction they influence the price of gold. This will be done in smaller parts; in each part one of the factors will be discussed. 6

7 Price of gold ($) Inflation correction The graph below shows the price of gold for which it is traded on the market and the same price but then corrected for inflation. So the 1990 price of gold which was 351 dollars per troy ounce corrected for the level of inflation would be similar to 605, 76 dollars in As can be seen from the graph the current high prices of gold is not so exceptional in the last 35 years we have seen similar price levels. In 1980 when the US suffered very high levels of inflation due to the oil crisis the price of gold rose to 607 dollars per troy ounce; corrected for inflation this would be comparable to a price of 1571, 63 dollar per troy ounce in The price level witnessed in 1980 is actually the highest we have seen and the price level of the years thereafter remained low it was only till the midst 2000 s that the price level started to rise again. So looking to these numbers we can conclude that the current high price levels are not as uncommon as we might think. We have seen a period of almost 15 years of stable and quite low gold prices. The question remains what factors drive this rise of the gold price. Is the economic cycle causing this price rise or is there another factor of influence? Figure 1: Shows the price of gold corrected for inflation Inflation corrcted price of gold Gold Bullion LBM U$/Troy Ounce (~U$) Inflation corrected gold price

8 Inflation volatility If we look at the graph of US inflation and compare it to figure 1 it is hard to see any form of correlation; this is not what the literature says. Baur and McDermott state that when inflation volatility is high the demand for gold and thus its price will increase. This is true for the period around 1980, were we see high inflation levels and increasing gold prices. During the current financial crisis however we see something totally different: inflation is at very low levels while gold prices keep rising to very high levels. Another link between inflation and the price of gold given by Baker and van Tassel (1985) is that the price of gold rises when inflation in the US is high, since the price of gold is denoted in dollars. Here again we see that is true looking at the period around 1980, but not if we look at the current period. So the link between inflation volatility and the demand for gold is a rather vague and uncertain one. Figure 2: Shows the level of inflation in the US. Jewelry demand The available data on the demand for gold from the jewelry sector only covered the last 11 years so it is hard to say what the link between the jewelry demand for gold and the price of gold is. What we can see is that after 2001, when the world economy went into a recession due to the burst of the dotcom bubble, demand for gold declined. Demand slowly increased in the years after the crisis, to drop again at the moment the financial banking crisis broke out. With demand levels for gold even lower than during the dotcom crisis. This is also shown in the graph below. 8

9 Demand for gold (per metric ton) So there seems to be a link between the state of the economy and the demand for gold by the jewelry sector. This can be explained by the fact that jewelry is seen as a luxury good and thus very elastic. So when the economy cools down consumers demand for goods and especially luxuries goods such as jewelry tend to decrease. This explains why the demand for gold by the jewelry sector decreased both in the period after the burst of the dotcom bubble and after the burst of the house market bubble which led to the financial crisis of Obviously it is a rather fragile link because the period for which we have data is not that long. This corresponds with what Baur and McDermott (2010) found in their research namely that the demand for gold by the jewelry market tend to follow the economic cycle. Figure 3: Shows the demand for gold by the jewelry sector per metric ton. 3,500 Jewelry gold demand 3,000 2,500 2,000 1,500 Jewelry gold demand 1, Industrial demand The graph bellows shows the industrial demand for gold there was only data available from the last 20 years. As can be seen the general trend during the last 20 years was an upward one. Again just as we saw with demand for gold by the jewelry sector, industrial demand also witnessed a decline in demand in 2001 and , due to the dotcom 9

10 Demand for gold (per metric ton) respectively the financial crisis. This rise of the industrial demand for gold during the last 20 years can be explained by the industrial growth we have seen in the last decades. Especially the high tech market, such as computer chips and other electronic chips, has grown a lot in the last 30 to 40 years. Since the production of these chips demand gold it is a logical consequence that industrial demand for gold has raised so much. That industrial demand for gold decreases in times of economic crises can be explained by the fact that computers and some other electronic devices are viewed as luxury goods just like jewelry. But computers can also be seen as investments especially concerning companies. So when the economy runs into a crisis people tend to wait spending their money on goods they don t really need and companies might wait a few years with doing big investment purchases, so this is why the industrial demand for gold drops in times of crises. Again this is also what Baur and McDermott (2010) found in their research, namely industrial demand for gold following the economic cycle. Figure 4: Shows the demand for gold by the industrial sector per metric ton. 450 Industrial demand for gold Industrial demand for gold Dental demand For dental gold demand there was also only data available for the last 20 years. Looking to the graph below it is hard to say what influences the demand for gold from the dental sector. The general trend seems to be that less and less gold is demanded, especially the 10

11 Demand for gold (per metric ton) last 5 years demand decreased heavily by almost 30 percent. Whether this decrease in demand is caused by the financial crisis is hard to tell. Baur and McDermott state that the dental demand for gold just like that of jewelry and industrial demand, move along the economic cycle. Where this seems to be true for industrial demand and jewelry demand, as was mentioned earlier; this link is less obvious for dental demand. There might be other reasons for a decreased demand for gold by the dental sector. It could be that due to innovations the dental sector starts using other materials instead of gold. This point is also supported by a research of Corti and Holiday (2005) that state that because of the availability of cheaper alternatives for gold in the dental sector we have seen a decreased demand for gold. Even though there is only data available for the last 20 years the general trend seems to be that the dental sectors demands less gold so this would mean that the price of gold is not positively influenced by the dental sector. Figure 5: Show the demand for gold by the dental sector per metric ton. 80 Dental demand for gold Dental demand for gold

12 Percentage GDP growth GDP growth As the graph on world GDP growth below shows, GDP over the last 33 years has been growing on an average rate of approximately 2,5 percent. This means that around the world consumers income has increased and with that also their spending increased. Increased spending could also result in an increased consumption of gold or gold consisting products. Another thing that can be observed from the graph is that the GDP of China and India has been growing on an average rate of 10 respectively 6 percent. The increased GDP and thus level of income in China and India might by one of the explanations of an increased demand of gold. Especially since gold fulfills a very traditional role in these countries. This observation seems to be in line with what Starr and Tran (2008) found in their research. India being the largest consumer of gold in the world might have a very large influence on the price of gold because the increased level of income in this country combined with its growing population (over 1 billion people) could lead to an enormous growth in the demand for gold. Figure 6: Shows the percentage GDP growth per year, for the World, China and India GDP growth World GDP growth Chinese GDP growht Indian GDP growth Interest rate There are two different trends that can be noticed from the graph below giving the relation between the price of gold and the interest rate level in de US. At the one hand 12

13 Logarithmic scale, giving the interest rate in % and gold price in dollars we can see that until 1987/1988 the price of gold and the level of the US interest rate are correlated, with the price of gold following the interest rate. This implies that a higher US interest rate would cause the price of gold to decrease. This is also in line with what Baker and van Tassel (1985) found in their research. After 1988 the correlation between the price of gold and the US interest rate becomes a bit vague, but still there seems to be an effect of the US interest rate on the price of gold. At the year 2000 interest rates started to decline rebounding a bit in the period 2005 to 2007, to decline to even lower levels after the financial crisis broke out in the fall of The price of gold in this period starting in 2000 has been steadily rising, so the low interest rate seems to have increased the demand for gold. Even though the correlation is not so clear looking at the graph it does seem the case that US interest rate has a negative effect on the demand for gold. Figure 7: Shows the link between the US interest rate and the gold price Effect of US interest rate on the price of gold US interest rate Gold Bullion LBM U$/Troy Ounce (~U$) Inflation corrected gold price Commodity prices In the last 20 years we have seen quite stable commodity prices until 2003, when commodity prices exploded and almost quadrupled. If you compare the trend of the commodity price index, given in the graph below, with the gold price, we see a similar 13

14 Index number (2005=100) trend in which prices start rising around the midst 2000 s. This could imply that the demand for gold increases along with the overall increased demand for all commodities. This is in line with what Baker and van Tassel (1985) found in their research. Figure 8: Show the commodity price index developments. 200 Commodity price index Commodity price index Investment speculation To see if the current high gold prices were caused by an increased speculation on gold I used data of the global investment demand for gold. The data available on investment demand only covered the last 20 years, because of that I also added the stock price of a company (ASA gold and PRMTL.) that sells gold in different investment forms. I did this because if investors demand more gold then it is likely that this company will sell more of their product and thus its stock price will rise. Because of this link it is highly probable that the stock price of this firm is highly correlated with investors demand for gold. As we can see from the graph below the investment demand for gold has risen a lot during the recent crisis. In 4 years time the amount of gold demanded by investors almost quadrupled. The total amount demanded by investors which was 1524 metric tons in 2011, is quite large if you compare it to the total amount of gold demanded every 14

15 logarithmic scale year, which is just over 4000 metric tons. Since the increased demand for gold is more than 30 percent of the yearly demanded amount of gold it is likely that this increased demand has a significant influence on the price of gold. We can also see from the price development of the stock price of ASA, that at the start of the crisis in 2007 the price rose by almost 30 percent to decline again in 2012 when the greatest fear was gone. This observation is also in line with what Baur and Lucey (2010) found in their research. Investors tend to use gold as a device of wealth protection in times of declining stock prices. Figure 9: Shows the stock price of ASA gold and PRMTL and the investment demand for gold Investment demand for gold Stock price of ASA Global investment demand for gold 1 Constructing the model Looking at all the variables discussed in this part we can say that we found some interesting results, which differ from what, was expected looking at the existing literature. Some links that I expected to find were not even there, while others were even stronger than was expected. So to resume I will briefly repeat the variables discussed. The model that was constructed due to the literature was as follows: 15

16 Demand for gold=jewelry demand+ industrial demand+ dental demand+ level of inflation+ GDP growth+ interest rate level+ commodity prices+ Investment speculation All of these variables seem to have some influence on the demand for gold, but not in the same way the literature suggested. In my opinion the physical demand for gold should always be the most important demand side factor. If there is no physical demand for gold then gold doesn t have any intrinsic value, so the fact that investors like to uses gold for several reasons is based on the fact that gold is a scarce product needed for all sorts of physical purposes. If we look at jewelry and industrial demand, which are the two main physical demand sides, we see different trends. With roughly 4000 metric tons of gold demanded every year, jewelry demand is responsible for more than half of the yearly demand with 2100 metric tons demanded. We can see that the demand for gold by the jewelry sector follows the economic cycle and because of that has declined in the last years. Industrial demand, which accounts for more than 10 percent of total demand, has risen steadily over the last years. During periods of crisis demand stagnated, but it picked up quickly after the crisis was gone. Dental demand, which accounts for 1 percent of total demand, has been declining over the last years not because it follows the economic cycle, but because due to innovations other materials then gold are being used. Because of this declining demand for gold by the dental sector, we might expect that its share of total demand will decline to levels so low that it doesn t influence the price of gold anymore. That is why I decided to drop the factor dental demand from the model. So if we look at physical demand, which is about 66 percent of total demand, this amount has been declining in the last 6 years. Looking at the investment demand which accounts for 34 percent of total demand, this demand has raised a lot since the start of the financial crisis. With a demand of 400 metric tons a year before the crisis, the increased investment demand may be the most important reason of the increased price of gold. If we look at a model for demand without investment demand it would be a logical consequence to think that the demand for gold and thus its price would have declined over the last 6 years. However including investment demand in the model gives the opposite result. In my opinion this is an alarming observation, since it seems to be so that the recent explosion of the gold price is mainly caused by an increased investors demand. It even looks like the start of a new bubble, which could cause enormous damage to the 16

17 world economy. The relation between the intrinsic value of gold and its nominal value seems to be completely gone. Gold has no use to investors and because of that no value, the only value it has for an investor is its liquidity. An investor can only store gold in his fold waiting till the moment he wants to sell it again. Investors can t use gold in a physical way, they can t make jewelry out of it, they can t produce computer chips using gold and they can t use gold for dentistry purposes. Since the product gold is useless to an investor he depends on the high liquidity level of gold, but what if physical demand drops even further? If the demand for physical gold declines even further then investors will be unable to sell their gold holdings. This would cause a huge drop in the price of gold, resulting in big losses to investors. 5. Conclusion So what drives the demand for gold? The existing literature describes two different types of demand for gold, being physical and investment demand. Although there are differences within the researches, most of the factors influencing the price of gold are quite similar among the different researches. The main physical demand factors are jewelry and industrial demand; all of these factors are found to move along the economic cycle. Countries where gold fulfills a very traditional role, like China and India also influence the physical demand for gold. In those countries GDP has raised a lot in recent decades and due to that their demand for gold has increased as well. The investment demand for gold is more complex, because it is influenced by a lot of different factors. Investors use gold as inflation protection, as storage of wealth in times of declining stock prices. Since gold is denominated in terms of dollars, changes in macroeconomic features in the US also influence the demand for gold. Dollar exchange rates, US interest rates and US inflation rates are factors that can influence investors demand for gold. In this research I found that the current level of the gold price is not as exceptional as is often suggested. Correcting the price of gold for inflation shows that we have seen even higher price levels in We can also see that the physical demand factors indeed follow the economic cycle and because of that have decreased during the last 6 years. Investment demand has moved in the opposite direction, mainly caused by 17

18 the uncertainty due to the financial crisis. The investment demand for gold has quadrupled in 4 years time, this because of declining stock prices and investor searching for secure assets to store their wealth. So again if we look at what determines the demand for gold and thus the price, we see two different things. Before the crisis the main drivers behind demand were physical demand, which rose steadily. During the crisis however we have seen that the increased investment demand drove up the price so much that it is now at a point at which we should ask ourselves the question whether this situations is sustainable. I think that the main driver behind the price of gold, as for any other asset, should always be its physical demand. If the current trend continues we will end up in a situation in which we have a bubble in the price of gold, if that bubble bursts the consequences could be devastating. Further research is needed to investigate if we are really creating a new bubble. Therefore a more extended data research would be needed in which all relevant factors should be examined in more detail. This can be done by an econometric research in which, the correlation between the different variables found in this research can be tested. This might give some new insights in how the variables influence each other and which variables react more heavily on certain changes. I think that it is very useful to continue on this research since I think this research came to the alarming conclusion that physical demand for gold is declining and investment demand is rising. If this trend continues with eventually the gold price bubble bursting, we might end up in another big global crisis. That crisis might even be one of the worst we have ever seen; since gold is probably the most important international liquid asset and almost every financial system global wide depends on gold in some form. References Salant, Stephen W. Henderson, Dale W. 1978, Market Anticipations of Government Policies and the Price of Gold. Journal of Political Economy, Vol. 86, No. 4, Barker, Stephan A. van Tassel, Roger C. 1985, Forecasting the Price of Gold: A Fundamentalist Approach. Atlantic Economic Journal, Vol. 13, No. 4,

19 Baur, Dirk G. McDermott, Thomas K Is gold a safe haven? International evidence. Journal of Banking & Finance, Vol. 34, Issue 8, Kaufmann, Thomas D. Winters, Richard A The price of gold: A simple model. Resources policy, Vol. 15, Issue 4, Baur, Dirk G. Lucey, Brian M. 2010, Is Gold a Hedge or a Safe Haven? An Analysis of Stocks, Bonds and Gold. The Financial Review, Vol. 45, Issue 2, Govett, M. H. Govett, G. J. S. 1982, Gold demand and supply. Resources policy, Vol. 8, Issue 2, Starr, Martha; Tran, Ky, Determinants of Physical Demand for Gold: Evidence from Panel Data. The World Economy, Vol. 31, Issue 3, Corti, Christopher; Holliday, Richard, Increasing gold demand: new industrial applications. Applied Earth Science, Vol. 114, Number 2, World Gold Council. DataStream. 19