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Having lived in India most of my life, I have always wondered at India's fascination with gold (SPDR Gold Trust ETF: GLD). For a long time, I never understood why everyone wanted their fair share of the yellow metal. It took me a long time to understand that women genuinely felt attracted to it and it took me even more time to understand that the yellow metal was a status symbol. People estimated each other's status by the kind of gold ornaments they wore. Meanwhile, the country I lived in was growing and it's earning power was increasing every year. As gold prices kept rising, people kept buying. I was confused that this might continue for a long time, and I kept wondering when something would give.

I was not bearish or bullish - while starting to write this article, all I wanted to know was why gold had been going through a phenomenal bull run for the past 11 years. Gold went up when the market went up. It went further up when the market went down - and it's still moving closer to the top. What are the logical reasons behind this increasing valuation? Well, some of the most talked about reasons are:

1. Gold demand is rising faster than its supply

2. Central banks around the world are hoarding gold and are buying more

3. Inflationary Pressures and Fear

4. The Indo-China Angle

The Demand and Supply Equation

A product's price is decided by the amount of supply versus the amount of demand. But the equation is not so plain and simple. Commodity prices are decided in the commodities market, bringing the expectations of supply and demand into play. Traders buy and sell commodities based on their expectation about future supply and demand equations, thus pushing the price higher or lower.

"Successful investing is anticipating the anticipations of others" - John Maynard Keynes

Supply: There are two primary ways in which Gold is supplied: Mines and Recycled Gold. Mine production increased 4% in 2011 and it has been slowly increasing since 2009 mainly due to additional capacity from established mines. Finding new mines is not easy, so adding more capacity to existing mines is very important. Countries like India and China have extremely active recycling markets. Recycled gold supply will depend on gold price expectation, cost and availability.

Demand: The three primary drivers of gold demand are Jewellery, manufacturing technology products such as semiconductors, and Investments. The investment category has a large mix of participants, such as regular investors, central banks, funds, ETFs etc.

Click to enlarge

Jewellery remains the highest source of demand with 48%, closely followed by investments. Together India, Greater China and China accounted for closer to 61% of total demand in 2011.

Conclusion: Supply has been growing slowly in the past few years, but Jewellery demand will depend on world economic growth - in India and China in particular. Investment demand will increase if we enter into recessionary periods.

Why central banks hold gold

All banks need some reserve assets that are readily available to them in times of need. Most central banks around the world hold dollars, euros and bonds in their reserves. With global currencies wildly fluctuating and bonds around the world getting more and more toxic by the day, central banks prefer the no-nonsense inflation hedge provided by Gold and are adding it in tonnes to reduce dependency on other assets.

Central banks in emerging markets are buying more gold in order to reduce their dependency on the dollar or euro. Gold is liquid and not correlated closely to any other asset class, not even to its own supply demand equation. United States, Germany and France hold more than 70% in gold in their total foreign reserves.

Which banks are buying

Contrary to popular belief, the Central banks of developed nations are either holding their gold reserves or selling gold. The net buyers of gold are the Central banks of emerging markets, Russia and few other smaller countries. The top 20 central banks hold more than 90% of the entire world's gold reserve and the following chart details the net change in reserve gold held by the banks in the past ten years.

The change after 2008 is not because all central banks started buying gold, but because few countries did. In 2009, India, China and Russia bought close to 780 tonnes of gold. Russia further added 140 tonnes in 2010 and 94 tonnes in 2011.

Conclusion: The Central banks of developed nations are happy with what they have. Even during the 2008 recession they didn't add gold to their reserves, they kept selling it. Emerging market banks, China and Russia are increasing their gold position and diversifying their reserve assets.

Inflationary Pressures and Fear

Though no one says gold prices are going up only because of inflation, it does play an indirect role in the price rise. With most central banks around the world engaged in monetary easing, inflationary fears and the expectation of weakening local currency pushes investors and banks to hedge their position using gold. The global downturn and shrinking consumer confidence has reduced inflation in major economies. But when growth is slow, central banks will resort to stimulus, increasing the odds for future inflation.

Conclusion: Inflation or deflation, as long as economic concerns and fear remain, investment demand for gold will remain steady.

The Indo-China Angle

In 2011, India and China accounted for approximately 61% of total demand. When a country's economy grows, it puts more money into people's hands - which is, in turn, used by them. The more the growth, the more the demand for gold will be. If these economies slow down, then the demand for gold will automatically dive.

But there is one more problem, the price rise. If the price of gold keeps going up and up, there will be a point where buyers in these countries will start buying lesser as they are not able to afford that much money. The strength of local currency can also pay a major role here. For example, the Indian currency weakened steadily against the dollar this year. While the price of gold dropped around 10% in the global market this year, the price of gold kept moving higher in India due to the country's weak local currency.

Gold Price in Indian Rupee Chart

Gold Price in Indian Rupee data by YCharts

Conclusion: If India and China grow well, people will earn more and buy more gold. But if gold prices rise too fast compared to the earning power, then people will prefer to buy less - reducing demand. Both economies have slowed down recently and whatever happens in these two countries will directly impact gold prices.

Source: Gold: The Supply-Demand Equilibrium