A new global currency: Calculating a ‘fair price’ for gold

Published: February 20, 2012

COMING THROUGH: 1.5% is the annual growth rate of gold stock.

RIYADH: Like many, I have been confused as to what to make of the boom in gold prices over the last decade. Should I heed the analysts and buy at $1,500 per ounce; gambling on the expectation that it will appreciate to $3,000 per ounce? Here, in the interest of investors who may not always know what to make of the incessant speculation surrounding gold, I have attempted to calculate a range within which the price of this metal may fluctuate in the long run.

Gold has traditionally been difficult to value as it has limited industrial use: it pays no dividends and is used primarily in the making of jewelry. It was used as virtual currency in the past, but the world economy was considerably smaller than what it is today while the practice was in vogue. Nonetheless, it is this historic use of gold that drives the modern speculation that gold has become pricier over time due to the eventual devaluation of paper currency, and the consequent potential return to a gold standard.

To evaluate the claim, let’s crunch some numbers. There is estimated to be around 170,000 tons of gold above ground. Annual production is around 2,500 tons, so the growth rate of gold-stock is only around 1.5 per cent per annum; making it a precious metal. Of the existing gold above-ground, around 80 per cent is used for jewelry, with a fraction being used in medicine and dentistry. Around 20 per cent – around 34,000 tons – is utilised for investment purposes, stocked mainly in the vaults of different national banks.

To calculate the fair-value of gold in the hypothetical situation that it becomes benchmark currency, one has to consider the size of the world economy (the gross domestic product of all nations combined).

This is roughly $65 trillion per annum. The velocity of money, or how many times a year each unit of cash is used, is around 9.0 in the United States. This means that a single dollar bill will change hands nine times every twelve months in the US. As the developing world has a much lower velocity, let’s take 6.0 as a rough weighted extrapolation for the rest of the world.

In this case, the amount of currency needed to run the economy would be around $10.8 trillion (because every dollar of the $10.8trillion will be used 6 times, totaling $65 trillion in transactions by year’s end). All of this electronic / paper money will be convertible into gold on demand.

Now let us assume that once gold becomes a currency, the level of gold used for investing purposes will rise to 50 per cent, from 20 per cent. The assumption is tenable, because when gold becomes expensive, many will be tempted to sell idle stocks of jewelry.

The estimated fair value of gold, in this case, would be the amount of currency needed, divided by the total gold-stock available for investment purposes. That is $10.8 trillion divided by 85,000 tons – which equals $127million per ton, or approximately $3,970 per ounce.

Even in this scenario, we will still want to use some paper currency instead of gold coins, because even a lowly one gram gold coin would be worth around $132. This would seriously affect the divisibility of such money for smaller trades. Silver coins, on the other hand, would be a much more practical currency since the metal is 50 times cheaper than gold – but that is another discussion altogether.

In conclusion, I want to present some final qualifications. I do not expect a return to a pure gold standard and prices to touch $4,000 per ounce because gold reserves are skewed in favor of a few countries such as South Africa. It will, therefore, be an inherently difficult proposition for the international community to agree on.

A basket of precious metals may be a way forward; in which case the value of gold will be weighted with other ores and therefore reduced. Even if gold is weighted as two-thirds in this basket, its fair value will fall to $3,000 per ounce. I will still call this an outlying scenario, as it remains to be seen if our hypothetical currency, backed by precious metals, will be too restrictive for future economic growth. This was primarily the reason why the original gold standard was abandoned in the first place.

A major downslide for gold prices is possible to levels below $1,000 per ounce, or even $500 per ounce. If world governments are willing to get their fiscal deficits in order instead of printing more and more money, inflationary fears would ease and confidence may be restored in paper currency. This would significantly ease the demand of gold that arises due to the devaluation of paper currency. I, however, do not see that happening anytime soon. Structural issues in the current democratic systems prevent such long-run policy measures.

Recommendations

I can see gold going up to $2,000 per ounce, but that would probably be the time to sell. By those levels, the possible risk of holding gold, to the rewards that might be had for holding it longer, may not be favorable.

The writer is an investment banker in Saudi Arabia.

Published in The Express Tribune, February 20th, 2012.

Reader Comments (13)

  • Ali Tanoli
    Feb 20, 2012 - 5:02AM

    Either china replaced the Dollar or Mideast oil rich countries decide to make it there own crruncy bassed on black gold OIL…

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  • Asad
    Feb 20, 2012 - 7:48AM

    ‘If world governments are willing to get their fiscal deficits in order instead of printing more and more money, inflationary fears would ease and confidence may be restored in paper currency.’

    Right! no possibility of this happening.

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  • John B
    Feb 20, 2012 - 9:46AM

    The rising middle class in Asian countries where gold is traditionally consumed for jewelry at 22 carat level will likely increase the gold price to $2100-2400. Beyond that would take a decade. After all, gold reached $1920/ounce last august. The vending kiosks will only increase the demand by novelty and souvenir purchases, beyond the traditional demand.

    Return to gold standard? That is a thing of the past. Modern economy is of high velocity and too big to be tied to a precious metal.

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  • Ali
    Feb 20, 2012 - 10:01AM

    You live in a hypothetical world !

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  • Feb 20, 2012 - 10:18AM

    My Dear Friend Usman,

    I have been researching on the topic of precious metal for some time and I found your article very insightfull. Thank you so much for sharing your recommendations and future outlook on gold.

    I hope that you do give a recommendation on silver. In my opinion it won’t be long that silver will outrun gold in terms of demand and price. Would you agree to that?

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  • Feb 20, 2012 - 11:17AM

    Dear Usman,

    Gold usage in jewellery is 50% and not 80%. With passage of time it is becoming expensive and difficult for medium and lower class to buy gold so they are turning towards other metals. Another way to calculate Gold value is to use M3 position against US Gold reserves which comes to some $10000 and in new few years it will rise considerably. However it does not mean that the actual price should be the same as there is huge manipulation going on by central banks and major global banks who do not allow the gold price to rise considerably.

    @Emad
    Silver is not a full alternate to gold. As I found out that in jewellery a mix of gold, silver, lead and few other metals are used. Due to high cost of solar energy Silver may not be able to take its rightful place any time soon. All the good talks about Silver comes from the Silver miners and Silversmiths. There is alot of manipulation in Silver which is why it has failed to even breach $50. If we use M3 and SBP Gold reserves one gram of Gold have a fair value of Rs.153000+. I’m expecting big time Rupee devaluation in future.Recommend

  • Feb 20, 2012 - 11:39AM

    I was looking at figures over the weekend and just counting Moneybase with 40% coverage ratio, I ended up with $3500/oz. When you start to adjut Gold price for M1, it goes to like $7200 and M2 shot up to something like $26,300/oz

    So it really depends what you count as MONEY.

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  • Feb 20, 2012 - 11:53AM

    @Imad Ansari: Historically there has been a parity band of 45~60:1 b/w silver vs gold.

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  • Amadeus
    Feb 20, 2012 - 3:17PM

    Actual fact based talk on tribune – this is unreal.

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  • Feb 20, 2012 - 5:30PM

    QE3 will push gold higher. If the Euro crisis worsens that should send the dollar higher and gold lower. So investing in gold at current levels is a risky proposition.

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  • Omair Anwar
    Feb 20, 2012 - 6:07PM

    You forgot to consider the amount of gold in the hidden economy.

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  • aaa
    Feb 20, 2012 - 9:21PM

    Your analysis is only true if the world economy is rational….but as far we know, the world economy jumps from one irrational bubble to another….and Gold will possibly be the next bubble, and everyone knows that in a bubble, Gold prices will be valued irrationally and when that happens, the sky will be the limit, until the bubble bursts.

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  • Shanti
    Feb 21, 2012 - 2:47AM

    Taking into consideration the shadow banking system (OTC-Derivates) who is still accounted largely off balance, you can immediately start adding some 0′s behind your numbers.

    The number of derivatives who are known (BIS) running already up to +700 TRILLION US$.
    When they go under water (and they will) they become debt on the balance, as that will be bringing banks in serious troubles, as on their turn they will be rescued by Central Banks by another round of QE (Quantitative-Easing). Central banks hold small part of their reserves in Gold. To balance their accounts, a (serious) revaluation on the POG (price of gold) is inevitable.

    Paper (Fiat) currency has the function of a medium of exchange, GOLD is a store value.

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