India, China and Gold

Includes: IFN, UDN
by: Aiki14

The Reserve Bank of India in an off market transaction purchased 200 Metric Tonnes of Gold Bullion from the International Monetary Fund (NYSE:IMF). Several things made this both interesting and market moving.

First, the magnitude of the purchase was surprising. Second was that they were not expected to make the purchase at all, analysts expected a large buy from China and the rest sold in market to the regular IMF Affiliate Banks. Lastly, they paid for it not in SDR’s or Special Drawing Rights as is the common practice when dealing with the IMF but in Hard Currency.

What did each of these things mean to the market and how will they affect the future?

1) The magnitude of the purchase.
Gold rallied over 3% on the day after this announcement. The fact that a sovereign bank was willing to pay top dollar for so much gold was very stimulative to the price.

2) India was not the buyer the analysts had picked for the purchase.
It is likely in light of this other sovereigns will follow, possibly China or some of the other Asian central banks. This will be a significant up force in the price of gold going forward. It is quite likely China, which has expressed an interest in moving away from the US dollar, may take this step. Additionally, political events related to trade conflicts recently may influence China to use this type of move to send a message to the US. The visit next week by President Obama may mitigate or exacerbate this possibility.

3) They paid for it in hard currency not SDR’s
This is much more subtle, and was much more difficult to analyze. The SDR’s are comprised of a basket of currencies as explained in the link in the reference section of this blog. India holds a large position of reserve currency, but it is comprised almost exclusively of US Treasury Securities and US dollars. So essentially they paid for this large cache of gold, which they are going to hold as a proxy for a reserve currency, in US Dollars.

This is tantamount to saying they would rather have gold than dollars. The immediate effect was twofold. First it caused the US dollar Index (USDX) to fall, and the price of the US Treasury securities, primarily the 30yr Bond, to fall. Second it stimulates the other sovereigns to do the same thing to avoid being caught holding a US dollar or Treasury that is declining in value. While this has not as far as we know happened yet (The IMF doesn’t announce the sales until they are completed and the India purchase did not leak out ahead of the announcement) it caused enough fear in the market to cause the dollar to reverse it’s recent uptrend and drop. That drop is continuing.

Broader Market Effects
The value of the dollar effects the value of things that are denominated in dollars. US Treasury Securities, Equities, and Commodities. As the dollar loses value the price of US Treasuries goes down, and Equity and Commodity prices rise. As a result we saw a rise in Crude Oil prices and a large rise in Gold prices. Crude as a result of first order effects (dollar value decreasing) and Gold as a result of first and second order effects (Increased demand).

Longer Term Effects and Price going forward
The price of US equities will see decreasing effects of this event unless another similar event as describe above takes place. The effect on Crude will be subsumed by the normal supply demand effects and/or any disruptive event. The effect on Gold and US Treasury prices will be effected to a greater degree as the up force on gold of such a large purchase, and the implications for US Treasuries of such a vote of “no confidence”, will in my opinion be long lasting, and again should a second or more sovereign banks engage in the same type of transaction there will be an exacerbation of these effects that could be greater than a linear effect.

Some Ancillary Comments
In the research of this piece, I found that the mainstream media either elected not to mention the fact that the purchase was made in hard currency, or in fact stated outright that SDR’s were used, even though the conference call clearly included that statement, and no media outlet I could find stated the makeup of the hard currency that was used. Obviously the market knew the facts or correctly surmised it as the price of gold and equities was positively affected by the news, but the media totally missed what in my mind was the critical factor for the markets.

Disclosure: The author and The Wallingford Trust hold long or short positions or may hold positions in the future in the following:
CL_F And other Gold Futures, Physical Gold Bullion, ZGZ9 and other Crude Oil futures, DXZ9 and other US Dollar Index Futures, ZBZ9 and other 30yr Treasury futures, CVX, XOM, TBT, FPP

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