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IB Economics Extended Essay 2007

Why is the demand

for gold increasing

despite increasing

price of gold in

India?

Word Count: 3842

Name: Athul Ravunniarath

Candidate Number: 000638

Supervisor: Esther Chau

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Contents

Chapter 11.1 Introduction1.2 Hypothesis 1 (Consumer Demand)1.3 Hypothesis 2 (Lack of substitute due to cultural reasons)1.4 Hypothesis 3 (Investment Purposes)1.5 Hypothesis 4 (Industrial use)

Chapter 22.1 Background of Gold production and consumption in the

world2.2 The price of Gold over the past few years2.3 The Cultural background of gold consumption in India

Chapter 33.1 Proof for hypothesis 13.2 Proof for hypothesis 2

Chapter 44.1 Proof for hypotheses 3 & 4

Chapter 55.1 Limitations of this Extended Essay5.2 Conclusion and evaluation

Appendix A

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Abstract

The objective of this research is to explore the reasons for theincrease in the increase in the demand for gold against increasingprices in India for the last five years. India, the second most populouscountry in the world with a population of over 1.1 billion people andGDP per capita of hardly 3000 USD per annum is also the world’sbiggest consumer of the gold.

Gold perhaps the most valued and the most appreciated among all theknown metals to man has historically been valued and has been used

a currency standard at various points in human history. This rare andexpensive commodity is what once drove the Spanish Conquistadoresto plunder South America. One of the main reasons why gold isinteresting today is that the value of gold has not decreased in thepast couple of years and therefore is seen as a very stronginvestment.

In the past five years, there has been positive co-relation between theprice of gold and the demand for it in India. From my observations andthe surveys conducted I have discovered that the reason for thisincrease in demand against this increase in prices which goes against

the demand-supply relationship is due to a variety of reasons rangingfrom very strong cultural affiliations to gold as well as simpleinvestment purposes.

Word Count: 222

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Chapter 1

1.1 Introduction

India is the biggest consumer of gold in the world. Around 18% of thetotal production of gold in the world is consumed in India which isaround 800 Tonnes. In the last 5 years, despite the price of goldincreasing in co-relation to the price of oil, the demand for gold hasonly gone up. The growth in the demand for gold is at almost alarmingstage. This relation between the price-rise and the demand is what

aroused my interest in the topic. I have come up with some plausiblehypotheses for this.

1.2 Hypothesis 1

Increasing GDP per CapitaThe increase in the demand for gold is directly linked to the increasingGDP per capita of the country or perhaps an increase in the disposableincome of the average middle-class Indian and thereby increasingconsumption of gold jewellery.

1.3 Hypothesis 2

Cultural ReasonsIndian society has traditionally been very attracted towards gold. Andtherefore despite the increase in price of gold, the society feels theneed to purchase gold and gold jewellery. It does not have asubstitute and is a necessity to the Indian cultural life.

1.4 Hypothesis 3

Investment purposesSince a long time the prices of gold have only increased over time.This may have caused investors to invest in a reliable and steadysource of returns such as the basic gold metal.

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Chapter 2

2.1 Background of Gold production and consumption in theworld

Roughly 2600 Tonnes of gold was produced in 2005. Roughly the sameamount was being produced for the last couple of years peaking in1999 with a little over 2600 Tonnes being produced. The major

producers of gold are South Africa, Australia, USA, Indonesia, Peru andChina. One of the very distinct features of gold is that Gold is never‘consumed’ like oil. It is possible to recycle and reuse the gold. In factit is even possible to amalgamate all the gold ever mined in the worldsince man started mining gold. Very little of the gold mined has beenlost completely. And some of the ‘consumption’ of gold these days issimply investment where the gold is left as it is.1

Only around 120000 Tonnes of gold have been mined throughout thehistory of man. 120000 Tonnes, which is the total global hoard of gold,

is such a small volume that it can be transported in a single oil tanker.The entire worth of the total hoard is about 1.4 Trillion US Dollars.2

The major consumption of gold is to make jewellery. Around 82 % of the gold produced is used to make jewellery, 6 % for medals ad officialcoins, 6 % for the manufacture of electronic equipment, 3 % fordentistry, and another 3 % in a wide variety of industrial applications.As stated before, India is the biggest consumer of gold in the worldaccounting for 18% of the global consumption followed by the UnitedStates with 14% and followed by China. 3

1 http://www.lbma.org.uk/statistics_current.htm2 http://about.reuters.com/productinfo/s/gold_price_history/3 http://www.gold.org/value/stats/statistics/prices/index.html

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2.2 Price of Gold over the last few years

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4 http://www.gold.org/value/stats/statistics/images/avpriceofgold1900-2005.gif

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5 http://www.kitco.com6 http://www.gold.org/value/stats/statistics/images/dailyshort_1.gif

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As we can see from the graphs above, the price of gold has alwayskept on increasing. The only exception in the long term was the goldprice crash in the mid 1980s which is directly linked to the oil pricecrash in that time period. Otherwise we can see that the price of gold

7 http://www.gold.org/value/stats/statistics/images/dailyshort_8.gif 8 http://finance.indiamart.com

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has steadily increased in the long term from 1900 to 2006. Over 106years.

2.4 The Cultural background of gold consumption in India

Gold is one of the few metals in the world to be used as a currency. Ithas been used as some form or currency or other since around 560 BCtill the end of the Bretton Woods system in 1971. This linking of goldto currency is one of the reasons why people still feel and believe thateven if the monetary system was to fail, gold would still be valuable.

One of the major drivers of gold demand in India is the cultural valuestied to the purchase and the use of gold. Weddings and the weddingseason account for nearly 60% of the 600 Tonnes of gold jewellery

consumed in India.9

Traditionally, parents give the bride the gifts of gold jewellery in order for the bride to financially independent in herhusband’s household. This is because gold is one of the most highlyliquid metals ever known and is considered by most Indians to be avery monetary asset. And for the last couple of decades theperformance for this metal has been exceptionally strong. If this istrue, the demand for gold will be price inelastic for up to the 60% of the gold demanded by the wedding season because of the belief people have in the performance of the metal. The chances of pricesgoing down are negligible and therefore gold will be gifted to brides inorder for her to remain financially independent in her husband’s

household. This means that even the price of gold increases, the rough60% gold demanded by the weddings cannot decrease, because it isclose to being a necessity.

Not only weddings, but other strong reasons include the festivalDiwali, when maximum gold is purchased, and other religiousoccasions such as Onam and Pongal. The Indian Hindu calendar alsoencourages purchase of gold during certain auspicious days to bringluck and fortune to the family. Gold is also purchased during the birthof a child. In fact a female child has her ears pierced with gold studs

as early as 6 months from birth.

I have again tried to prove this hypothesis, which is the demand forgold is price –inelastic to a certain extent because of the culturalaffiliations to gold by the Indian community by a sample surveyconducted in both urban and rural areas about price elasticity involvedwith cultural reasons.9 http://www.goldinspirations.com/headlines/2005/01/19/story/7600534/

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Chapter 3.1

India is the largest consumer of gold jewellery in the world followed by

the United States of America. This is despite the fact that India is athird world country with the per capita income hovering around 550US$ per annum while the per capita income in the USA is around40,100 US$. According to the World Gold Council, Jewellery accountsfor the largest share of final demand for gold. This is approximately70% of the total demand for gold and worth approximately 40 BillionUS$. 10

As per the figure given above, we can see that India is the majorconsumer of Gold jewellery. By volume India consumes approximately590 Tonnes of gold jewellery in a year. As I have noted in Chapter 1,the annual total consumption of gold in India is approximately 800tonnes; which means that jewellery accounts for almost 74% of the

total gold consumption in India.

“Speaking to DNA Money, Varij Sethi, managing director, SB&T said,"Jewellery is one of the fastest growing and most profitable segmentsin the Indian retail space today."” 11

10 http://www.gold.org/discover/knowledge/amazingfacts/index.html11 http://www.dnaindia.com/

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India is generally one of the most price-sensitive markets in the world.Generally, value for money is a big deciding factor when it comes topurchasing any sort of luxury goods such as electronic appliances andautomobiles. But the price of gold has not gone down and has been onan upward trend for the last couple of years; hence it is not the price

factor that is driving up the demand for gold. Therefore a simpletheory to explain the increase in the price of gold could be related tothe fact that the booming middle-class in India is spending more ongold as they have higher disposable incomes. I have used a samplesurvey to prove that the demand for gold is income-elastic to certainextent. That is if people have more money to spend, then the spendingon gold will increase. I have surveyed over 100 consumers in jewellerystores in both urban and rural parts of the country.

The per capita GDP has been increasing ever since the 1970s andcontinues to increase even today.

Per Capita GDP 1970 - 2005

0

100

200

300

400

500

600

700

800

Period

1972

1975

1978

1981

1984

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Year

U Per Capita GDP

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Per Capita GDP 1995 - 2005

0

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600

700

800

1995

1996

1997

1998

1999

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2001

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2004

2005

Years

U Per Capita GDP

We can see that the per capita GDP has almost doubled since 1995from 392 USD to a little over 720 USD. Because of this fact thebooming middle class contributes to growth of the gold sector andpurchases gold as they have more disposable income.

Also the population of India has boomed and has almost doubled fromabout 500 Million in the 1970 to 1.1 billion in 2005.

Population

0

200,000,000

400,000,000

600,000,000

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Year

Populatio

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Both these factors cause an external shift in the demand for goldespecially gold jewellery. The demand curve shifts outwards as shownbelow.

As we can see from the figure above, the price of gold is driven up byincreasing demand from the consumers who these days have more tospend because of higher disposable income.

As per the government of India figures, around 25% of the populationof the country falls into the middle income category.12 This 25%translates into almost 300 million people. This figure was hoveringaround 6% of the population in the mid 1980s; which was around 50million people. There has been a growth of almost 250 million in thiscategory. This means that the population almost the size of the UnitedStates has been empowered with a higher purchasing power. This willautomatically translate into higher purchase of gold. Out of this 25 %population in the middle class, 10 percent has just broken into themiddle class layer in the last 10 years. The top 5% is almost on theverge of becoming upper class. In the last one year there has beenaccelerating trend of about at least 1 percent of the total populationbreaking into the middle class. It is an accelerating trend. Along withthis massive middle income population, around 10% of the populationis reported to be in the high income group. With the New Economic

12 Census India 2001

www.censusindia.net

D’

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policy being implemented in India in 1991, the figure has beengrowing exponentially.

One of the features of the middle class group around the world is theconsumerism. As they earn more money, they will consume more. This

is true in the case of the gold consumption. In the GDP of India,private consumption as part of the GDP was only 50% in 1990; thishas increased up to 65% in 200413. All these have contributedeffectively to the consumerism.

In the survey that I conducted, one of the questions was “If your

salary or profits increased considerably, do you think your purchase of

gold will also increase accordingly?”

Most of the survey takers responded that they would purchase more

gold. Their main argument for doing that was that, when they earnmore, they would need to spend and invest more. And therefore theywould be willing to spend more money on gold. Percentage of peoplewho think their consumption of gold would increase with respect to theincrease in their incomes

73, 77%

22, 23%

Consumption-Salary

As we can see from the graph above almost 77% think that theirconsumption would increase. In the survey that I conducted, only thehigh income group in the urban areas said that they would notpurchase more gold with respect to their incomes; While the middleclass and the lower income groups were almost 100% sure that theirconsumption would increase.

13 Reserve Bank of India: The Economy in 2005

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High Income Group

7 7

14

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Urban Rural Total

Middle Income Group

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Urban Rural Total

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Lower Income Group

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1 0 1

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25

30

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Urban Rural Total

As we can see from the graphs above, other than the urban Highincome group, almost 100% of the respondents said their purchasewould increase along with the increase in their incomes. Anotherquestion on my survey was what amount the person spends onpurchasing any form of gold in a year. Most of them came up with areply that it would be hard for them to estimate the amount they spenton gold in a year. Most of them said that it varies year to year with theoccurrence of different reasons like weddings, anniversaries etc. Thenext question on the survey was did the respondent feel that theamount they spend on gold increased over the years. Most of themsaid they spend more on gold because the price of the gold keeps

increasing and even though the quantity of gold purchased doesn’tincrease, the amount spent on gold keeps increasing. But the generalconsensus was that more people felt that they were in a position tobuy more gold than they were 15 years ago. They attribute this to thegeneral rise in their incomes is far more than the general increase inthe price of gold. The price increase in Gold is around 98% from 1990to 2005. The growth in per capita income from 1990 to 2005 is around110%. This could probably be the reason why people in the countrythink they are able to afford more gold and that their generalconsumption of gold has increased.

We can also explain this effect using indifference curves.

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The increase in the income will cause a parallel shift in the demand forthe gold; which is shown in the diagram above as the increase indemand from X1Y1 to X3Y3.

In conclusion to this chapter, I would like to state that one of themajor reasons for the increase in demand and the price of gold aredirectly linked to increasing purchasing power of the middle incomegroup of the Indians who make up almost 250 million of thepopulation.

3.2

The second hypothesis for the increasing demand for gold despite the

increasing prices is that the Indian society is traditionally affectionatetowards gold. I think there are a lot of cultural reasons that affects theaverage Indian consumer’s mentality when it comes to buying gold. Ihave given many cultural and traditional reasons associated with goldin chapter 2.3. With my survey, I was further able to establish thishypothesis of cultural reasons. This is because; through the survey Iwas able to find out the reasons why some consumers buy gold.

I was able to draw up a preference chart for both rural and urbanconsumers indicating their preference towards Gold, silver or platinum.As I expected, most consumer prefer gold.

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Precious Metal Preference Chart

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2

10

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76

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00

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Gold Silver Platinum

Urban Precious Metal Preference Chart

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No. of Peopl

High Income Group

Middle Income Group

Low Income Group

As we can see from the urban preference chart, gold is preferred bymost people from varying income groups. But we can see that there isalmost the same preference for platinum and gold amongst the higherincome group. This probably because the Higher income groups do not

buy gold as an investment and probably only as ornaments or fashionaccessories and hence have the same preference for platinum as well.There was also a rising preference for platinum among the middleclass as well while there was no interest at all for platinum among thelower income groups. There is also a significant preference for silveramong the lower income group; probably because of its affordabilityand liquidity.

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Rural Precious Metal Preference Chart

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00

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No. Of People

High Income Group

Middle Income Group

Low Income Group

As expected, most people prefer gold to any other precious metal.Unlike the urban areas there was very limited interest in platinum andthere was similar interest in silver. But the preference for gold is veryhigh.

Precious Metal preference Chart

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9

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No. Of People

Ur

Ru

This is the combined chart showing preference in rural and urbanareas without factoring in the income differences.

The second question on the survey was also tied to the reason for thepreference of gold. The second question was regarding the reason forpreferring gold. The reasons for the attraction were quite diverse. Infact most of the respondents to the survey gave different answers. All

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the reason I received (from the people who said they preferred gold) islisted below:

• Value never decreases

• Necessity for weddings

• Investment• Easily Liquidable

• Looks good

• Lasting

• Re-moldable

Most of the answers overlapped quite a lot. But from the abovereasons we can see most of the reasons for the attraction of peopletowards gold.

In fact one of the ladies I had surveyed coming from the rural part of the country and a member of the lower income group responded thatshe prefers to buy gold just for the reason that it is safer to keep goldthan liquid cash. Because if you buy an ear ring with the 2000 rupeesthat I save, then I can always keep that amount on me by wearing theear ring. But if I keep the money in the house, then my husband justuses it up for buying alcohol. At that point, I asked her why not open abank account and she responded that she did not trust the banks andbanking services in general.

The third question was also a part of this series of questions. What is

your current reason for purchasing gold?

Current reason for purchase of gold

47, 66%

6, 8%

14, 20%

4, 6%

Wedding

Investment

Jewellery/Fashion

Gift

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There were only four solid reasons I got from 71 people who were inthe jewellery to buy gold. The four reasons were investment, wedding,fashion/accessory and gifting. I have graphed the number of peoplebuying gold for different reasons. As said in chapter 2.3 weddingsaccount for the most of the gold sales in India. On some average days

during which the surveys were conducted, over 66% of the crowd thatcame with the intention of purchase gold were there because of wedding related reasons.

As I said in chapter 2.3, weddings account for almost 60% of the 600Tonnes of gold sold in India; which is approximately 360 Tonnes of gold. I did not conduct the survey during the peak of the weddingseason. Yet, 66% of the gold sold was due to wedding reasons.

Now half the population of India is under the age of 25. Almost 600Million people are under the age of 25.14 This means that more numberof young people getting married could directly result in an increase inthe amount of gold being purchased for wedding reasons.

Therefore for the next two decades, as long as the average age of thepopulation is less than 25, then the consumption of gold due tomarriages is not going to decrease. The average age for marriage isbetween 26-29 years. Because of the cultural affiliations towards goldand the need for gold during marriage, the demand will not decrease.

14 Census 2000

Price

Quantity

DD’

S

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The fifth question in the survey also invoked quite a surprisingresponse quite contrary to the economic theories I have learnt. Thequestion was, if the price of gold increased further, would you stillpurchase the gold? The response of the majority of the respondentswas that buying gold was unavoidable and there will be consumption

of gold whatever the price of gold.

8 8 8

4

12

6

13

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15

3

0

2

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UrbanYes UrbanNo RuralYes RuralNo

HI

M

LI

As we can see from the chart above, very few people said that theywould not buy gold if the price increased. A big proportion of them

were the urban Lower income group which said that they will not beable to afford gold if prices go up even more. Some of the rural andurban lower and middle income groups said that they will borrowmoney from banks and loan sharks if the price goes up so that theycan buy gold because they cannot avoid buying gold.

The questions 8 and 9 evoked similar responses to the question above.Most said that there are situations in which buying gold becomesunavoidable especially during marriages. Some of the respondents saidthey will buy gold however high the price is, if there is a wedding in

the family.

I would like to conclude this chapter saying that, a major reason forincreasing demand for gold despite the high prices is the culturalreasons linked to the purchase including the need of gold jewellery inmarriages.

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Chapter 4

One of the reasons for the high demand for gold is the investmentrelated purchase of gold. As I have said before, gold is one of the fewmetals that have always had a constant growth rate. Therefore many

people invest in gold; especially in the form of bullion as aninvestment purposes. In an interview with the Senior Investmentmanager of Franklin Templeton India, he mentioned that seriousinvestment in the form of gold bullion is limited to the urban highincome group and middle high income groups. The urban incomegroups due to their increased income over the past few years havediversified their investment portfolio from stocks and bonds intosomething more stable and tangible like gold and silver. The majorconsumers of gold bullion are people who are averse to riskyinvestment like stocks and bonds. The gold bullion demand hasincreased in the last 2 years with the extreme fluctuations caused inthe stock exchanges. Since gold is a more stable investment, peopleprefer to invest in gold. The urban high income groups also investheavily into real estate along with gold.

Again the demand for investment is there because the price of gold isincreasing. One of the questions in my survey was if the respondentwould buy gold if the price of gold declined. All the respondents whoconsidered gold as an investment said they would reduce theirconsumption of gold especially for investment reasons if thathappened. Although most of the respondents claimed that that

situation would never happen given the history of gold.

My last hypothesis for the increase in demand for gold was probablythe unavoidable rise in the industrial consumption as part of the neweconomic policies since 1990. But apparently the industrial use for goldin India is very minor and is not significant enough to cause aremarkable difference to the price of gold. One of the industries thatrely heavily on gold though is the dental and dentistry. With increasingincomes and disposable incomes, the demand for gold filling and goldteeth have increased ten fold. Even then, this demand is negligible and

the industry is really insignificant.

Chapter 5

Limitations

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The most serious limitation is that a lot of assumptions and claimsmade in this extended essay were based on a survey which had amere 95 participants. The survey which generalizes the entire situationin India is based on simply two locations in the same southern state of Kerala in India. I don’t think that such a small sample size is enough to

prove a serious claim and hypothesis.

Conclusion

With this research I have tried to show the reasons for why thedemand for gold is increasing in India despite the increasing prices of gold throughout the world. It was observed that the cultural tiestoward gold in the Indian society along with increasing per capitaincome and the disposable incomes of the middle class Indian is themost significant driver of the demand for gold.

I think the major drawback of this excessive consumption of gold isthat the capital used for the purchase of gold could actually be used todevelop industries and for proper investment purposes and or socialdevelopment.

I will end this essay with a quote from the ex-American FederalReserve chairman Alan Greenspan "Gold is an irrational exuberancewhich may lead to a financial asset Bubble!” That is Alan Greenspan

giving a warning about the situation in India.

Word Count: 3842

Bibliography

1. Andrew Gillespie. Advanced Economics throughdiagrams. New York: Oxford University Press. 2001.2. Paul A. Sammuelson, William D. Nordhaus.Economics (17 th Edition). USA: McGraw-Hill HigherEducation. 2001.3. www.gold-eagle.com

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4. http://serc.carleton.edu/research_education/nativelands/pi neridge/golddeposits.html

5. Census India 2001, Government of India 20016. Reserve Bank Of India, Economy: An Outlook7. New York Mercantile Exchange. www.nymex.com

Appendix A

Survey Questionnaire

1. If you were given the option of purchasing the option of Gold, silver

and platinum, which would you prefer and why?

2. What is the reason for the attraction to gold?

3. What is your current reason for purchasing gold? Wedding,

investment etc

4. Even though the price of gold is at its highest levels in a long time,

why do you still purchase it?

5. If by any reason, the price of gold increased even further, will you

still buy gold?

6. If your salary or profits increased considerably, do you think your

purchase of gold will also increase accordingly?

7. If the price of gold decreases, will your consumption increase?

8. Are there factors by which buying gold becomes unavoidable?

9. If there is a wedding in the family, will you purchase gold

regardless of the price?

10. Do you think gold has a very high resale value?

11. Do you purchase gold for investment purposes?

12. In a year, what amount do you spend on buying gold jewellery?

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13. Has this amount increased over the years?

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