Paul van Eeden

Understanding the gold price
August 11, 1998

There seems to be confusion among both investors and analysts regarding the cause of gold price fluctuations. In this letter I will attempt to elucidate the most important components of the gold market as they relate to price movements of the Midas metal. In the end I hope to show you that the gold price is less sensitive to mine supply, fabrication demand or central bank sales than what is commonly accepted. Instead, the single most important influence on the gold price is simply exchange rates between different currencies.

The supply deficit myth
Much has been said over the past several years about the supply and demand deficit in the gold market. Generally, the supply of gold is considered to be essentially mine production and scrap sales. This is offset by fabrication demand, which has exceeded the supply of gold for thirteen out of the last fifteen years. Fabrication demand can be broken into two main components: jewelry fabrication and industrial fabrication. Other forms of gold supply include private and official gold sales from stockpiles, forward sales by producers and hedging by speculators. Additional demand for gold such as private and official purchases and demand for gold loans also enter into the supply-demand equation.

But by far the most important factors influencing the gold price would be the most inelastic forms of supply and demand, viz. mine supply and fabrication demand. Mine supply is by nature inelastic due to the cost and time that it takes to develop new deposits and bring new mines into production. Once in production, mines cannot easily change the amount of gold they produce, nor can they shut down for a few months because the price of gold drops. In essence mine supply is a function of the number of mines in production and it rises as new deposits are discovered and brought to account. Due to the increasing use of gold in fabrication, scrap sales of gold have also increased. This form of supply is now fairly large relative to mine supply and will continue to play an important role in the supply-demand dynamics of the metal.

Similarly, fabrication demand is the most inelastic form of demand. Among the two components of fabrication demand, jewelry fabrication is both the largest component and the least inelastic. But it is widely spread among nations so that when demand increases in one country it is often offset against demand declines in another country and vise versa. Industrial fabrication, which is made up of electrical and other forms of fabrication, is inelastic since gold components are usually a very small portion of the final product and thus changes in the cost of these components have a relatively small effect on the cost of the final product. Also, gold has very unique chemical and physical properties, which limits the ability of manufacturers to substitute other metals when the price increases.

When the price of gold is reasonable, fabrication demand is fairly inelastic. It increases as the world’s economies grow. During times of reasonable gold prices, fabrication is by far the most important form of demand and outweighs investment demand as an influence on the gold price. Currently gold prices are reasonable; hence the most important aspect of demand is fabrication demand.

By looking at the table below it is easy to see why many gold analysts construct a bullish case for gold. Taking into consideration that the price will be affected primarily by mine supply, scrap sales and fabrication demand, we can see that over the past 10 years the gold market has suffered from a substantial supply deficit averaging 319 tons per year from 1988 to 1997 (319 tons is roughly 10,257,000 ounces).

Table 1 : Annual gold supply and demand in metric tons showing the supply deficit calculated by subtracting the supply from the demand. One ton of gold is roughly equal to 32,154 ounces. (Source: GFMS on Bloomberg)


Mine and Scrap Supply

Fabrication Demand

Supply Deficit (tonnes)

Supply Deficit (ounces)












































































Because the gold price hasn’t increased over the last ten years in proportion to the supply deficit noted in Table 1, we can conclude that the supply and demand fundamentals as represented above do not determine the gold price. In fact, despite the overwhelming increase in the deficit between 1996 and 1997, the gold price actually declined during those two years from an average 1996 price of $386 an ounce to $330 an ounce in 1997.

How central bank sales and investment demand influence the gold price
Gold analysts who have been tracking central bank sales (official sales) may note that during the past ten years such sales have increased dramatically. That may explain why the gold price has not increased but instead decreased. If we add central bank sales, hedging and forward sales to the supply of gold and add investment demand to fabrication demand, then the market is more or less in balance. In fact total demand must equal total supply as in any other market. However, the numbers show that overall there was net disinvestment of gold.

To observe the relationship between gold disinvestment and gold prices, refer to Graph 1 below. It is immediately obvious that there is a strong correlation between investment demand and the gold price, with or without including forward sales and hedging programs. What is important though, is to try and determine which is the cause and which is the effect. Do investment increases or decreases change the gold price, or does a change in the gold price result in changes in investment demand? According to Graph 1 the answer is unclear. In 1984 the increase in investment preceded the 1985 increase in the gold price, but in 1987 and 1991 the gold price changes preceded the investment changes. The truth is probably that sometimes investors correctly anticipate gold price changes and sometimes they don’t. That is at least what one would expect, but it does imply that the gold price decline since 1995 is not necessarily due to central bank sales or any other form of disinvestment.

Graph 1 : Disinvestment and Disinvestment plus forward sales since 1983 together with the gold price over the same time period. The average annual gold price was used. (Source: GFMS on Bloomberg)

Another way to reach the same conclusion is to note that late in 1997 the London Bullion Market Association reported that on average approximately 1000 tons of gold traded through them each day. Early in 1998 they reported that activity had increased to around 3000 tons a day. Gold not only trades in London, but also in New York and Hong Kong. While this volume includes derivative trading, the conclusion remains the same. If the volume of London trades alone is in excess of 3000 tons of gold per day, how can annual changes of maybe 500 to 1000 tons of investment demand make any difference to the gold market? The total value of net investment is just too small to make an impact on the gold market. Consider a very large central bank sale of say 300 tons occurring over a period of several months. Such a sale would have very little or no long-term impact on a market that trades in excess of 3000 tons a day. This fact is also clearly illustrated by looking at a gold price chart and noting the date of past central bank sales.

Over the past two years several European and other central banks, most notably the Australian and Argentinean central banks, have sold substantial portions of their gold reserves. This has caused pandemonium in the gold market and fueled speculation that gold is being demonetized. Such central bank sales have been held responsible for the declining gold price and much emphasis has been placed on further potential sales from Europe in preparation for monetary union sometime this year. Below is a graph of the gold price for the last two years.

Graph 2 : The gold price in US dollars from January 1996 to April 1998

In March 1996 Belgium sold 203 tons of gold representing 31.8% of its reserves. Neither the announcement nor the sale made a meaningful impact on the gold price. So right off the bat we have an indication that central bank sales and the announcement of such sales do not, by virtue of being central bank sales, make an impact on the gold price. However, the Dutch sale announced in January 1997 of 300 tons, representing 20% of their reserves, did make an impact on the gold price. But it was the announcement rather than the sale that did most of the damage. Within two weeks of the announcement the gold price had fallen more than $15 an ounce and within three weeks of that the price had recovered to where it was prior to the announcement. The announcement of a smaller sale of gold in July 1997 by Australia of 167 tons, representing 68% of their reserves, made an even bigger impact on the gold price. This time the gold price plummeted more than $20 an ounce before it regained most of the loss and stabilized. Then in December 1997 Argentina sold 124 tons of gold, representing 90% of their reserves, and once again the gold price dropped sharply and recovered. The really interesting central bank sale occurred on March 18, 1998 when Belgium sold another 290 tons of gold to five other central banks. Gold dropped roughly $5 in intra-day trading but closed only $0.60 lower for the day. Since then the gold price has increased from $291 an ounce to over $310 an ounce.

Throughout the period starting around February 1996 until March 1998 the gold price declined steadily and consistently with the exception of the time periods around which announcements of major central bank sales were made. It seems as if the announcements of such sales caused greater damage to the gold price than the sales themselves and the gold market almost always rebounded quickly afterwards. This can be interpreted as substantial short selling or disinvestment by private funds after the announcement of a central bank sale. Short selling or private disinvestment was probably due to investors interpreting the central bank sales as proof that gold was being demonetized, or else trend investors who saw gold on a downward trend and central bank sales as confirmation that the trend was in place and had momentum.

It can be argued that the steady decline in the gold price since 1995 is in fact due to the increased central bank sales even though an analysis of the actual events do not necessarily support it. But our attention is again drawn to the size of the gold market and the relatively small size of the central bank sales discussed earlier. Also, while some central banks were net sellers of gold, others were net buyers. Many more central banks buy and sell gold than what is reported in the popular press. For example during 1996 there were 16 central bank net sellers and 19 central bank net buyers of gold. The data for 1997 has not been released yet but according to Goldfields Mineral Services, there were 14 central bank net sellers and 19 central bank net buyers of gold during 1997. It seems as if the whole idea of central bank sales suppressing the gold price is just the most obvious explanation that presented itself and it was accepted without due examination. From a market perspective it seems unlikely that central bank sales are the sole cause of the declining gold price, even though they contributed to it.

Is gold money?
Many people believe that gold is no longer a necessary component of international money supply. They note that the well-publicized central bank sales are confirmation that gold is no longer associated with money or necessary for monetary stability. In fact, gold is nothing more than a commodity.

If gold is a commodity like rice or aluminum, then it should be priced as such. It would seem that under such circumstances, gold is the most overpriced commodity in the world. The value of gold as a commodity stems from its physical properties: electrical and thermal conductivity, resistance to corrosion, malleability and ductility. The biggest market for gold will be in the electronic industry where it will compete with other metals, notably copper. If gold were to truly compete with copper in mass production of electrical components then the price of gold would have to be competitive with the price of copper. Copper trades for around $0.80 a pound and gold for more than $4,000 a pound. This means that the gold price would have to drop to less than $0.06 (six cents) an ounce to be in the same region as the copper price. Obviously gold is not being priced as a commodity. There is a demand for gold that inspires people to pay substantially more for it than its commodity value. Gold is money.

Remember the South East Asian currency crisis last year? Both South Korea and Thailand publicly called for their citizens to turn in any private gold (coins, jewelry, etc.) The Thai and South Korean governments needed the gold to rebuild their foreign reserves after losing the battle to save their defunct currencies. Now if gold is no longer money, why on earth would these two countries need their citizens’ gold? The fact is that in times of financial crises all countries still have to turn to gold. Gold is the only form of money that is not someone else’s liability.  Paper money is only as good as the credibility of the issuer and paper money issuers are losing credibility, which could in time force the world back to a gold standard. This recent experiment with fiat money is not the first in the history of the world. All of the previous attempts to create fiat money ended with devastating effects; this one is bound to have the same outcome.

Aristotle defined the ideal form of money to have these properties: durable, divisible, convenient, consistent and it has to have value in of itself. Anyone who cares to test will find that there is no other substance on the face of our planet, which can meet these requirements as well as gold can. Again because of its physical properties, gold is our best form of money. Of course the US government would like the dollar to be the universal money and they almost succeeded. Strangely though, the reason why the US dollar is the reserve currency of the world has to do with gold.

The US dollar as the world’s reserve currency
In 1931 President Roosevelt confiscated all privately held gold in the United States. After the confiscation, the US government offered to pay first $17 an ounce and then later, in 1934, $35 an ounce for foreign gold. A substantial portion of the gold in the world was sold to the United States and every dollar outside the US was convertible into gold. It was these two elements, the fact that the US owned a large percentage of the gold and the fact that the dollar was convertible into gold that enabled the US dollar to become the reserve currency of the world.

In 1971 when President Nixon reneged on the US’s promise of conversion it was too late for the rest of the world. There were too many dollars out there already and besides, no other major country’s currency was then still backed by gold so there wasn’t any quick substitute for the dollar as an international reserve currency. At that point it was also impossible for politicians to convert back to a gold standard, as it would have required astronomical gold prices. So the US dollar remained the reserve currency, not because of the US’s huge economy, or its monetary and fiscal policies, but merely as a remnant of the time when the US owned the most gold and the dollar was convertible into gold.

The relationship between the dollar and the gold price
Let’s again look at a graph of the gold price, this time going back to 1970 (Refer to Graph 3 below). In 1971 Nixon reneged on the dollar’s convertibility and the dollar’s value plummeted.  Gold increased from an average of $41 an ounce in 1971 to $184 an ounce in December 1974. Because the dollar was the reserve currency of the world, most currencies devalued against gold.

During the 1970’s there was massive inflation in the United States, both to combat poverty within the country as well as to fund the Vietnam war. This lead to another round of currency devaluations later in that decade and gold increased from an average of $124 an ounce in 1976 to $629 an ounce in October 1980. During this crisis the United States sold 35% of its gold reserves to try and stop the dollar’s devaluation, in vain. Since then the US has not sold any gold except in special coin issues. Also since then the US dollar has been relatively stable against the gold price, which is probably due to gold being priced in US dollars and the IMF’s Special Drawing Rights being based on US dollars. But the dollar has devalued against most other major currencies since the late 1970’s, which is why gold has become cheaper in most other currencies since the early 1980’s, after the financial crisis abated.

Graph 3 : Relative gold prices in US dollars, Swiss frank and Japanese yen. The relative frank and yen gold prices were obtained by multiplying the dollar gold price by the corresponding US dollar exchange rate and then dividing the Swiss frank data by 2.5 and the Japanese yen data by 200.  (Source: Bloomberg)

If it is not immediately obvious why gold will get cheaper in other currencies as the dollar devalues against them consider this example using the Japanese yen. Assume that gold is trading for $300 an ounce and the dollar is equal to 120 yen. This implies that gold is trading for 36,000 yen. If the dollar devalues to 100 yen but gold is still trading for $300 an ounce, then gold will be trading for 30,000 yen. As you can see, the fact that the dollar devalues against other currencies implies that gold gets cheaper in those currencies since gold is priced in US dollars.

Of course if this were to happen the Japanese would buy more gold (so would every one else outside the US) and the gold price will be restored in terms of yen. To keep the example simple, assume the yen gold price goes back to 36,000 yen an ounce where it was before the dollar devalued. This would mean that the US gold price is now $360 an ounce. It is misleading to think of the gold price strictly in terms of US dollars. Gold trades all over the world in many different currencies and countries. The international gold price, while quoted in dollars, is dependent on the supply and demand for gold as well as the relative exchange rates between the US dollar and other currencies.

Referring to Graph 3 above we can see the following: In 1976 the Swiss franc and the US dollar were almost equal in relative value trading at roughly $124 an ounce. In 1995 the average US price for gold was $355 an ounce and the relative Swiss price was $165 an ounce showing that the US dollar lost 115% of its value against the Swiss franc from 1976 to 1995. In 1978 the relative average gold price was $200 an ounce in both US dollars and Japanese yen. In 1995 the relative average gold price was $181 in terms of yen reflecting that the dollar devalued 96% against the yen from 1978 to 1995. This devaluation of the dollar against both the franc and the yen explains why the gold price in terms of these two currencies declined during that time.

But most of the talk about declining gold prices revolves around the time since 1996 when the gold price fell from an average price of $386 an ounce for that year to $299 an ounce in February 1998. Speculation about a conspiracy against gold, the demonetization of gold and central bank sales have been offered as causes for the collapse of the gold price. While central bank sales do have an impact on the gold price, they are not the only reason why gold declined by more than 22% over the last two years.

The increase in the US dollar has caused the gold price to drop
The first thing to notice from Graph 3 is that although the gold price has declined by more than 20% in US dollars since 1996, that decline is not reflected in either Swiss franc or Japanese yen. In fact, from the average 1996 gold price to February 1998 the franc gold price is down only 9% and the yen gold price is down only 11%. This roughly 10% decline in the gold price started in February 1997 and is due mainly to increased gold sales by central banks, forward sales by gold producers, hedges and other private sales. The additional 12% decline in the US dollar gold price is due to something else.

Looking at the data in Table 2 the gold price history becomes clear. Since 1982 the US trade balance has decreased substantially. A trade deficit implies that US dollars leave the country and the amount of dollars held by foreigners increases. Because price is set by supply and demand, this increased supply of dollars outside the United States translated directly into a lower price for US dollars, hence the declining dollar. Because the gold price is quoted in US dollars, the gold price in other currencies declined as we have seen before, even while the gold price in US dollars since the early 1980’s has remained relatively constant. At least up until 1996.

Since 1996 the US dollar has strengthened substantially against foreign currencies and as we saw earlier, this would lead to a decrease in the US dollar price of gold. In fact since 1996 the US dollar has gained 13% against the yen and 15% against the franc. It can thus be concluded that more than half of the decline in the gold price as seen in US dollars is due to nothing other than the fact that the US dollar increased in value against international currencies since 1996. This is by far the most important influence on the gold price for US residents since their investment returns are measured in US dollars.

Table 2 : The US trade balance and net foreign borrowing. (Source: IMF data on Bloomberg)


Trade Balance ($ billions)

Net Foreign Borrowing ($ billions)












































































Increase in the value of the  US dollar is an aberration
Looking back at Table 2 again we see that net foreign borrowing by the US increased from $27.7 billion in 1994 to $188 billion in 1995 and remained at approximately that level during 1996. It is this tremendous increase in foreign purchases of US debt, as well as foreign investments in the US stock market, that has not only halted the decline of the dollar against foreign currencies, but actually reversed it so that the dollar increased in value.

The reasons for this influx of money into the United States are basically higher relative interest rates compared to Europe and Japan, declining inflation, the currency crisis in South East Asia, the debt crisis in Japan and uncertainty in Europe with regard to monetary union. In fact, the strength in the dollar is due to the uncertainty in the rest of the world, making the dollar relatively less risky. In absolute terms the dollar is not in that good shape when we look at the trade deficit and the national debt. It is unlikely that this amount of foreign investment in the United States will continue for an extended period of time. When foreign investment starts to decline again, the US dollar will come under pressure and the temporary strength in the dollar will disappear.

As I have shown, the most important influence on the gold price is simply the US dollar exchange rate. If the dollar gets stronger, the gold price declines. If the dollar declines, the gold price increases. While central bank sales and other forms of disinvestment do have an influence on the gold price, it is the dollar exchange rate that plays the most important role and it is the dollar exchange rate which up until now has been overlooked by most investors and analysts.

What will the gold price do?
Well, of course it’s impossible to predict with certainty, but if Japan manages to kick start its economy we may see more investment there and less in the United States. If the new euro (Europe’s new unified currency) has sufficient gold backing to convince the international community of its strength we may see it competing with the US dollar as a reserve currency. Any one of these two events could cause the dollar to decline. However, the dollar should eventually decline because of the United States’ trade deficit.

Under normal circumstances, the trade deficit will cause the dollar to devalue and in turn this will cause foreign goods to increase in price. More expensive foreign goods reduce the demand for imports and the lower dollar creates an international demand for US exports. Thus the declining dollar will eventually cause the trade balance to swing from a deficit to a surplus. A trade surplus will cause the dollar to start increasing against other currencies. With an increasing dollar, exports become less attractive to foreigners and imports become more attractive again, and the cycle repeats.

What we have at the moment is an aberration where in spite of an increasing trade deficit, the dollar is getting stronger due to foreign investment and this is exacerbating the trade deficit. But foreign investment is a short-term phenomenon and capital is quick to move when markets change. In contrast, the trade deficit has a long cycle time and it is well established. Even if nothing happens in the world to draw investors’ capital away from the United States, the ever-increasing trade deficit should overcome the effects of foreign investment, which would cause the dollar to decline and the gold price to increase.

I suspect that the fall of the dollar if it happens, and the concomitant increase in the gold price, will be unsuspected and rapid because of the level of foreign capital that will move swiftly when the tide turns.

What to do
We have seen a true aberration in both the value of the dollar and the gold price develop during the last two years. This represents an opportunity to profit from the decline in the dollar should foreign investment subside and the underlying fundamentals take over again. A US citizen or resident who wants to protect his or her assets against a declining dollar could invest in a diversified basket of quality gold producing companies. The high quality companies that are available should not only be able to withstand further declines in the gold price if our timing is somewhat out, but more importantly offer leverage to the gold price. For those people who are risk averse, investing in gold bullion coins can offer similar protection, but without the leverage.

Paul van Eeden

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