Precious in the Long Run

01/25/2010 11:35 am EST

Focus: GLOBAL

Lawrence Roulston

Editor and Publisher, Resource Opportunities

Chinese demand should support gold prices once the current consolidation has run its course, writes Lawrence Roulston in Resource Opportunities.

The impact on the metals markets of the sustained growth in [China, India, and the rest of] Asia has been dramatic. Metal prices fell sharply at the outset of the financial crisis, but have recovered strongly. It is important to recognize that the strong gains in the metal prices have come while the developed world is barely climbing out of recession.

The gold price is now consolidating after briefly exceeding $1,200 an ounce in December. Every analyst who comments on the gold market has a different explanation of what factors are driving the gold price through its daily gyrations. In reality, a worldwide audience of investors are making independent buy and sell decisions based on their individual interpretations of all of the factors that impact the market.

Some of the factors influencing the gold market are:

  • The financial crisis further damaged investors’ faith in financial assets and in paper currencies.
  • Some investors believe that the massive subsidies and liquidity injections into the worldwide financial system will ultimately lead to inflation.
  • The US dollar, being the most common measuring stick to value gold, has been under considerable pressure due to the economic situation in United States and the massive debt resulting from the stimulus spending.

Central banks have signaled their intention to continue to hold gold as an essential part of their foreign currency reserves. Some countries, notably India and China, are actively increasing the amount of gold in their holdings. The US dollar will continue to be an important part of the international reserves system. However, many nations will seek to diversify a portion of their holdings and gold will see a growing role.

The net result is that there will be less “official sector” gold available to the market in coming years then there has been over the past decade.

China has now surpassed India as the largest consumer of gold. The growing middle class of China is actively buying gold jewelry and other ornaments. The economic slowdown in the developed world saw an enormous drop-off in the sales of gold jewelry over the past year and a half. Recovery in the emerging economies should see a return to buying gold jewelry, which remains the biggest element in the demand picture for gold.

China is now also the world's largest producer of gold, largely from small-scale production throughout the country. Gold production in the rest of the world has been declining steadily since 2002. The gold mining industry is struggling to increase production, but expansion is constrained by the lack of available deposits suitable for mine development.

There are many reasons to expect the gold price to trend higher over time, with consumer demand growing, mined supply seriously constrained, and official-sector sales slowing. However, the big swing factor in the gold market is investor sentiment. Investors can switch from buyers to sellers in the space of a couple [of] computer keystrokes.

At this moment, gold appears to be in a consolidation pattern. The more likely trend is upward, but there remains a risk to the downside.

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