The Gold Book Annual

The market regards the outlook for gold as a function of supply/ demand forces, and one supply force stands out: the flow of central bank gold. This has led to a state of profound pessimism stemming from the belief that the world's central banks will sell off their gold. Other supply/ demand forces, if they are bearish, garner attention as well. Recently, the Asian currency and financial crises have been focused on as adverse shocks to demand.

It is because of this radical shift in thinking that we have devoted d the first issue of the Gold Book Annual to the supply/ demand fundamentals for gold. The gold market is functioning much like any commodity market: a huge supply of metal from the liquidation of a vast above-ground stock is straining the absorptive capacity of the market's principal commodity use - jewellery. A good parallel is the palladium market, where a vast Russian hoard of the metal has been under liquidation in recent years, providing the market with 40% of its aggregate supplies and depressing the price - until Russian supplies diminished in early 1997 and the palladium price exploded.

This year's edition of the Gold Book Annual tries to accomplish three basic goals:

• Identify supply/ demand variables whose values are erroneously estimated and widely misunderstood and estimate the true levels of supply and demand in the gold market.
• Understand and explain the short-run dynamics that govern the way the gold price responds to changes in this relevant supply/demand variables.
• Understand the long-run trends in the gold market that project future supply/demand conditions and explore their implications for the future price of gold.

Following is a synopsis of the main points covered in each chapter:

Chapter One, The Gold Supply/ Demand Framework, establishes the case that global gold demand far exceeds previous consensus estimates, thus implying a deficit in the market that is twice prevailing estimates.

Chapter Two, The Incredible World of Gold Borrowings, argues that gold is flowing from central banks at a rate far higher than anyone now believes, mostly in the form of borrowed gold. Outstanding gold loans are two to three times consensus estimates. These unappreciated Hows of borrowed gold constitute the 'hidden' supplies that correspond to the underestimated demands discussed in Chapter One. Most of these gold borrowings can be construed as short sales of some form or another. If they continue to grow, they will represent a source of gold market instability at some point in the future.

Chapter Three, Reconstructing Gold Supply/ Demand,1993- 1997, demonstrates how these new supply/ demand estimates are consistent with so much else we know about the gold market.

Chapter Four, Inventory Tides and the Option Hammer, moves toward the issue of gold price dynamics. It is widely believed that gold demand is extremely sensitive to changes in the gold price so that a sharp or even complete abatement in official supplies would have only a moderate impact on the gold price. We analyse these short-run sensitivities and argue that most of them are of a transitory nature.

Chapter Five poses the question, " Where Would the Gold Price Go if the Flow of Official Gold Were to Cease?" In our 'model' of gold's supply/ demand dynamics, if supplies of official gold were to cease entirely, price elastic demand rather than price inelastic mine supply would be the primary factor in determining new price equilibrium. Our conclusion is that after some lag, the gold market would clear at a price of $600 an ounce.

Chapter Six, The Strong Secular Trend in Gold Consumption, shows that growth in global gold demand, excluding both official and western investment demands, has been in the order of 5% per annum whenever the gold price has been constant in real (inflation-adjusted) terms over the past 25 years. This trend growth rate amply exceeds that of any other major commodity, as well as that of global GDP growth. It is likely that this trend growth rate will persist in the decade to come.

Chapter Seven is entitled "Dealing with the Disequilibria of 1997. In 1997, strength in the US dollar and the currency crisis in Asia depressed global gold demand. This chapter argues that both these negative factors will prove to be transitory.

Chapter Eight, Future Gold Supply/ Demand Balances and Their Implications for the Gold Price deals with the long - term future trend of mine and scrap supply. Historical records show that the second rate of gold mine supply is likely to be half that of demand. If the real (inflation-adjusted) price of gold remains constant, then today's large deficit in the gold market, which was zero only five to 10 years ago, will widen progressively and rapidly as the year's pass.

Chapter Nine, Past Patterns and Future Prospects for Official Gold Sales reviews attitudes of central banks regarding gold. There is much here that is not positive. Many central banks view gold negatively as an asset devoid of any return. However, it appears likely that recent undisclosed official sales have been of European origin, are EMU related and will abate or cease in the coming year or two.

Chapter Ten, The Positive Real Return to Gold, considers the key issue of gold's inherent long-run rate of return. Central bankers and the 'shorts' in the market believe incorrectly that gold is barren only because their expectations are based on the bear market of recent years and not on a longer-term perspective. A longer-term perspective should encompass not only the recent bear market years but the gold market of the 1970s - a bull market which was unprecedented in magnitude for virtually any major asset class.

Chapter Eleven, End Games, brings to bear all of the above analyses and simulates future supply/demand balances and Future gold price scenarios. These simulations show that, under a persistent low $320 price scenario, today's large gold market deficit expands at a rate sufficient to exhaust central bank coffer s of physical metal within a decade. At this point, the gold price must explode far above a price equilibrium that exceeds $1,000 per ounce. The odds are that long before this extended game is played out, today's sellers, becoming aware of such a possible outcome, will modify their behaviour. This would lead to an abatement of official supplies, resulting in an earlier rise. In all such cases, when a market that has been far removed from its long-run equilibrium returns to this equilibrium, it overshoots it and by a large margin.

Amidst the prevailing gloom in the gold market, these conclusions are shockingly bullish. We want to stress two things: first, our conclusions have been arrived at through a dispassionate analysis and second, our analysis need not have bullish implications for the short run. To a great degree, short-run developments lie with the central banks themselves: if they choose to sell gold intensely and lend it freely, they will depreciate the current value of the bullion they hold even if it is inevitable that it will eventually command a much higher price.