Gold

An Asset Class Called Governance : The Case For Selling Gold Against Something

Sanjeev

Sanjeev

For almost a decade, Gold has been the ‘trade of the decade’.  Buy the dull metal against almost anything: stocks, currencies, debt, anything but ‘precious commodities’, i.e. commodities in short supply, because India/ China are big incremental users of it. The relative movement of Gold has always been with lower risk/ volatility and it has always given higher risk-adjusted returns.  Importantly, Gold was the best place to be in, during the desperate days of late 2008- early 2009.

Declaimer: This article written was originally in October 2010, and some of the data points may be outdated.

Does it deserve such a standing in the world of Investment?

Does it deserve such a standing in the world of Investment? It has no productive use; the only feature that speaks for it is that its (incremental) supply is not in the hands of man. If some alchemist could suddenly find a way to produce Gold, it would have disastrous consequences for the world economy. The USD used to be the world’s ‘gold’ for a while, until fiscal and monetary indiscipline by the custodians of the Dollar’s reputation, brought about this current pass.

So has Gold reached bubble territory? A ‘bubble’ happens when asset prices rise, with a corresponding rise in debt levels, used to buy/ hold the asset. In the case of Gold, its prices are rising at a time when worldwide leverage is falling, especially in the developed countries. So the most important defining condition of bubble territory is not met. Hence, you should not expect a sudden collapse in the price of Gold, like it happened in the mid-eighties.

But you can expect (and should be prepared for) a slow letting out of the air, as its relative movement to some other assets (principally currencies) shows a drop in outperformance. This might even look like a price drop, especially if you think nominally (i.e. in terms of the home currency, say, Euro/ Rupee), but it will not be a bubble collapse.

Gold does well when Governance does not.

Gold does well when Governance does not. When Nixon delinked the USD from Gold, he gave unlimited cheque-writing powers to the US Fed. The powers got progressively misused, but there was some tolerance until Greenspan happened. Then came ‘helicopter Ben’, who may have had no intentions of actually dropping Dollar bills from helicopters, but was forced to virtually do the same, since he took over as Governor at the Fed. It took almost a generation, 30 years, for its reputation to catch up, but the USD today is a shadow of its former self, in terms of credibility vs. Gold.

Has US fiscal and monetary credibility reached its nadir? Is it time to buy this ‘value pick’ called US credibility? Is the US so chastened, that it will give up its entitlements, stop running a (Budget) deficit, and get its public debt in order? Already, individual Americans are behaving better, domestic savings are up and private sector leverage is falling, but it will take time to work away the excesses of the past.

The US Govt, however, continues to try and spend its way out of trouble. It is trying to replace falling private (domestic) demand, with more debt-fuelled Govt spending. Even as tax revenues fall, and the Govt Revenue Deficit balloons, its Public Debt ratio is doubling in the next 3 years. Yet, the US Govt is not ready to clamp down because its Bond markets have not revolted…yet!

So the drunkard is still at the bar, quaffing his 14th peg, and asking for more. The bartender is worried on both counts: can this customer pay his bills, and can he stand steady enough to go home? At some point in time, the bartender will call in the bouncers, usually the foreign country that is subscribing to the deficit in the bond markets. China puts in 8% of its 55% savings rate, into US bonds. That is not a small amount, even though it is reducing steadily.

Which brings me to the central question of this column. Gold has to be sold, simply because it has gone up for too long. Maybe it has still not gone too far, but it has gone up for too long….it should be time to worry now!

So where in the world has Governance reached its nadir?

So where in the world has Governance reached its nadir? That would be the country/ currency to buy, against Gold. Let me try a hypothesis: It could be Greece, maybe Argentina (which has twice gone to the cleaners). Who else has a bankrupt Govt, no tax revenues, huge Govt spending, and banana republic politics……all set to change!!! In effect, if Bihar was a separate country with its currency, that is what I am looking for…I would be buying Nitish Kumar’s governance!

I am looking for “the next Indonesia” to make the picture even clearer. Remember Indonesia in 1997: a tinpot dictatorship, huge spending imbalances (both private and public), and large real estate investments, all funded with short-term foreign borrowings. The result: was food riots, and a currency that went to nothing. An 83% drop in nominal currency rates against the USD, led to a monthly 83% drop in GNP, and a cumulative 43% drop in per capita GDP. Interest Rates went to 65%: in other words, a Great Depression that ensured that the economy in 2005 was still smaller in PPP terms than it was in 1997. No ageing population, no structural deficiency in demand, yet enormous political and economic upheaval, that will stay embedded in the psyche of its populace (and its politics) for at least a generation to come.

India went through something much smaller, but similar in 1991. Remember the Loan Melas of the 80’s and the subsequent NPA crisis in India’s banking sector? From that nadir, which hit us 20 years back, we now claim to have one of the most stable banking sectors in the world, a level of prudence that you don’t see elsewhere in Indian business/ politics.

So great disasters create huge psychological scars, which create sudden, corrective behaviors in populations: nobody even whispered about Indonesia, 10 years after the Asian Crisis in 2008. The US saw Paul Volcker in the Fed, shortly after the 1982 recession. The hardliner Guv, who took Fed Funds rates to 14% to combat inflation down from 12.8% to 3.5% is an example of how human behaviors can change dramatically and diametrically (opposite). The profligacy of Indonesia has been replaced by fiscal and monetary prudence, even as the “next thing to Gold, i.e. the USD” is a picture of fiscal and monetary imprudence.

These contradictions have been captured in the concept of the “historical process” enunciated by George Soros. One of the behavioral rules of “the historical process” is that every (behavioral) trend reaches an irrational crescendo before completely dying out, or reversing ‘permanently’. The Nazism of Germany was followed by democracy for the next 3 generations. Lebensraum is now a dirty word in Germany.  The Berlin Wall came down under one of the most Stalinist leaders of Communism, one who spent his entire life in the KGB. For a generation, India (and Asia) has been terrified of a Forex crisis, which has pushed up savings rates and the propensity to export (forex) surpluses, either through capital flight or through Central Bank investments.

So what is the answer to the questions I have posed at the beginning of this column? I do have an (automatic) answer, but I want to arrive at it through a structured process of exploring all viable alternatives.

Somewhere among the basket cases of Govt imprudence lying around the world, is a country that is going to come back very strongly. That country has some intrinsic competitiveness, but has got ‘caught in the crossfire’. Either it was growing, investing in Capex at the wrong time, and suffered an asset-liability mismatch, which has driven it to insolvency (Iceland? Ireland?) Or it had too much savings and lent it to the wrong part of the world (Austria? China? Japan?)

Such a country would be now gritting its teeth and putting in place an attitude towards savings and investment (or borrowing and consumption), which will improve its governance dramatically. It would help if the said country was currently in serious crisis because its currency/ bond markets would be reflecting that. Otherwise, there is no point in taking a contrarian position on Gold (i.e. selling it). If you buy Gold, at least you will be rich(er) in Dollar terms; so what if the currency is discredited by the end of the decade? You can always shift to the US and enjoy yourself….

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