News Hour- Multiple dangers ahead if gold price crashes

The world price of gold has crashed from over $1,800 per ounce to under $1,590 per ounce. This should sober the buying frenzy of both consumers and bullion speculators, who have driven up the gold price sharply over the last year. 

They have argued that gold prices can only go up for several reasons: the Fed is pumping out billions which are being financialised into gold derivatives; gold is a hedge against inflation; uncertainty about the euro future will cause a mass switch to bullion. However, nothing can keep going up forever, which is why bubbles burst.

Remember, gold shot up from $32 per ounce in 1971 to over $800 per ounce in the early 1980s and then collapsed to a quarter that rate. Nobody knows whether gold will crash in coming months, but we must guard against the possibility. Indian imports of gold and silver have shot up 56% in April-November to $44 billion, making this the second largest import item after oil. 

The World Gold Council says jewellery demand in India has actually fallen marginally in January-September, while investment demand has shot up 25% to 296 tonnes. This speculative frenzy has been encouraged by the financialisation of gold through a phenomenal expansion of gold loans by banks and non-banking finance companies like Muthoot and Manappuram. Some lenders claim they can process and give a loan against gold as collateral while you wait. 

However, how many borrowers know that if gold prices crash, they will have to put up additional collateral or have their collateral seized and sold? The lenders are also in danger: they might find that they have lent more than can be recovered from the crashing value of collateral, as happened in the US mortgage bust. 

So, the RBI needs to tighten up norms for lending against gold. The margins should be high and the total exposure of any lender to gold loans must be a modest fraction of all loans. Lenders must be obliged to explain the risks clearly to borrowers, something that was not done in the US mortgage market. 

It makes sense for the government to come out with inflation-indexed bonds, to offer investors a substitute for gold, as a credible hedge against inflation.

(Source- http://economictimes.indiatimes.com)