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Gold Prices and Financial Stability in India pdf

Gold Prices and Financial Stability in India


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Abstract

There has been an almost sustained rise in the international gold prices since 2002, with
just one deep correction in 2008. As gold is an integral part of savings of a large number
of investors, this has raised apprehensions whether any correction in gold prices will
have destabilising implications on the financial markets. In this backdrop, the paper
makes an attempt to analyse the implications of the correction in gold prices on financial
stability in India.
The paper covers empirical analysis on the inter-linkages between domestic and
international gold prices and then it examines the nature of changes in the factors
affecting international gold prices during the last two decades. While validating
empirically the existence of complete inter-linkages between domestic and international
gold prices, the paper goes on to conclude that there has been a structural shift in the
factors affecting international gold prices in 2003. Short-run volatility in international gold
prices used to be traditional factors such as international commodity prices, US dollar
exchange rate and equity prices. However, since 2003, the same is largely due to the
volatility in the US dollar exchange rate and mildly due to volatility in equity prices.
In conclusion, the findings of the paper show that domestic and international gold prices
are closely interlinked. Based on empirical evidences, the paper also concludes that
implications of correction in gold prices on the Indian financial markets are likely to be
muted.

Introduction

International gold prices have risen almost unabatedly in the last few years, though there
was one large correction in 2008. From July 2011 the pace of increase in gold prices has,
however, accelerated further and in the third quarter of 2011, gold prices rose much
faster. The spurt in gold prices which occurred in 2011 took place in the background of
worsening of financial and economic scenarios initially in the US, followed by the debt
problems in the European Countries. As a result of these adverse global developments
and “flight to quality”, gold is emerging as a “safe” asset for investment purposes.
The impact of the rise in international gold prices is reflected in its domestic prices as
well. Despite the sharp recent price rise, in India, demand for gold has sustained, not
only as a component of safe savings but also due to its social and cultural importance.
Therefore, movements in gold prices in India are of keen interest to all segments of the
society including investors. From the policy perspective, gold’s price rise has raised a
concern as to whether a future crash in gold prices would have financial stability
implications. Given this background, the objective of the paper is to analyse the
implications of the correction in gold prices on financial stability in India. The paper is
covered in six sections. Section II provides a brief review of literature relating to gold with
a particular focus on gold as a “safe haven”. Section III covers empirical analysis on the
inter-linkages between domestic and international gold prices. Section IV covers
empirical analysis on the factors affecting international gold prices. Theoretical and
empirical analysis on the relevance of gold price rise to the financial stability is covered in
Section V. Finally, broad conclusions are covered in section VI. References and technical
results of regression analysis are appended at the end of the study.

Inter-linkage between Domestic and International Gold Prices

Indians have a yearning for gold since the inception of civilisation. Gold demand has not
only remained high but has shown sharp rise in the recent period especially since 2001
as reflected in the increase in volume of imports. The demand has shown no signs of
abating despite incessant price rise. Lord John Maynard Keynes famously commented
that India’s gold consumption reflects the ‘ruinous love of a barbaric relic’. Incidentally,
India’s gold production continues to be minimal in nature. Almost all of India’s demand for
gold is met by imports. Before taking up a discussion on the inter-linkages between
domestic and international gold prices, it would be appropriate to review the gold policy in
India with a particular reference to the economic reforms in India.

Conclusions

One of the important findings of this study is that, presently, domestic gold prices and
international gold prices are closely interlinked. Variations in the international gold prices
find almost similar echo in the domestic gold prices.
Empirical analysis of the study also suggests that the factors affecting data generating
process of the international gold prices has undergone a structural shift in 2003. In the
pre-2003 period, macro fundamental such as international commodity prices, US
exchange rate and equity prices used to be the most dominating factors affecting the
international gold prices and their impact used to be identical both in the long-run and
short-run. In the post 2003 period, however, this relationship has weakened in terms of
its statistical and first and second order econometric properties.
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