John Dizard: Why gold is certain to move higher

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By John Dizard
Financial Times, London
Sunday, November 8, 2009

http://www.ft.com/cms/s/0/bf99d538-cb06-11de-97e0-00144feabdc0,dwp_uuid=...

The announcement last week of India's official purchase of 200 tonnes of gold from the International Monetary Fund put an amphetamine-like push into the metal's price. Before that news, the recent rally to new highs seemed to be tiring out, with the technicians citing this momentum line rolling over from that support level. The combined increases in open interest in the gold futures, and the gold held by the exchange traded funds, have not kept pace with the accelerated rise in the price of the metal; in other words, we have seen a rally on (apparently) weaker volume. That may not bode well for a strong gold market in the near future.

To my way of thinking, though, there has been other news of official doings, outside of India, that indicate a much higher gold price over the longer term, whatever happens over the next few months. It is not central bank gold purchases, though, that are the key support; it is the prospect of more extensive controls on the international flow of capital. Specifically, it was Brazil's imposition of a 2 per cent tax on capital inflows in October, not India's gold purchases that month, that was the most significant gold-positive signal. In the past, multilateral officials, such as the managing director of the IMF, would have murmured disapproval, with suggestions that anti-liberal moves such as this should be reversed as quickly as possible. Not now. Brazil's apparent attempt to keep down the real's appreciation, probably to ensure export competitiveness, is accepted and applauded by multilateral-dom as mainstream political economy.

As the IMF officials and their supporters in the academic community say, controls and taxes on capital flows do make it easier for policy managers to "limit bubbles," or slow currency appreciation. International capital flows do not necessarily support the short-term policies of a national political class or local elites. In Brazil, for example, manufacturers, miners, and sugar farmers would be forced by continuing currency appreciation to become ever more efficient and less monopolistic. The state would have to deliver more real and valuable services for its tax revenue. I would have thought those desirable outcomes.

The Brazilian tax and similar taxes and quantitative controls that have been imposed or considered elsewhere are only going to slow a long-term trend: the rise in the investment returns in newer market economies relative to those in the developed world. If the US and Europe are poking along at 1 or 2 per cent growth while Brazil, India, China, and the Gulf States grow at three or four times that rate, money will want to leave the first group and go to the second.

If it cannot do that, though, or if it is taxed highly for doing so, money will not just give up and buy Fannie Mae mortgages or Spanish bonds. If investors are restricted from bidding up emerging market assets, and, therefore, currencies, they will buy a substitute that is much harder to control: physical gold.

Andy Smith, a gold strategist with Bache Commodities in London, says it is not the buyers of the odd Krugerrand who are beginning to take over the buy side of the market. "It's the representatives of the Ma's and Pa's. The bullion bankers are being trained more on the retirement funds in the middle of nowhere, and less on the hedge funds." This means more of the rising base of buyer interest is in the metal, rather than derivatives. Many of them apparently prefer to have their gold in vaults near where they are, Mr Smith's "middle of nowhere," rather than in LME or COMEX warehouse receipts.

One indication of this, as he says, is the rising proportion of refiners and transport firms going to gold conferences. For example, the proportion of jewellers attending the London Bullion Market Association annual meeting has fallen from 16 per cent in 2000 to 6 per cent in 2008, while the proportion of transporters, refiners, security firms, and others involved in physical bullion movement has increased from 11 per cent to 18 per cent. Their customers "are not leveraged buyers, or buyers on margin,” as Mr Smith says.

If one were only interested in getting exposure to gold at a low transaction cost and had no concern about capital controls or taxation, then derivatives, or tradable warehouse receipts, are much more efficient. This gradual change in investor preference is about an inchoate fear of one government or another getting between the investor and his money.

Only a minority of investment managers and financial analysts have experienced exchange controls first-hand. If they consider gold, it is as an inflation hedge, which is not all that compelling at the moment.

My family lived in Warsaw from 1968 through 1970, years of insignificant Polish price inflation. But the aluminium zloty coins we had as spending money were completely useless outside the country, and not much good inside it. Inflation is only one way that private assets are devalued, and at some level more investors understand this.

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