Gold is the life belt for all seasons, especially the dangerous ones.
--Timothy Green

Gold and silver have been sought and prized since prehistoric times. They have also been both a cause of war and a medium of exchange.

Gold has traditionally been the standard by which the value of anything is assessed; it has also been a universally accepted medium of exchange. Silver does not lag far behind in the history of global trade. In fact, till the nineteenth century silver was actually more widely employed than gold as the standard of value.

The Indians' faith in God and gold dates back to the Vedic times; they worshipped both. Historian Pliny complained that her Indian trade drained ancient Rome's bullion resources. Indian merchants always demanded payment in silver during the times of the East India Company; so much silver was exported from London that East India Company teetered on the brink of financial disaster.

According to the World Gold Council Report, India stands today as the world's largest single market for gold consumption. In developing countries, people have often trusted gold as a better investment than bonds and stocks, particularly because historically these acted as a good hedge against inflation. In that sense these metals have been more attractive than bank deposits or gilt-edged securities.

Why people buy gold

Despite recent hiccups, gold remains an important and popular investment for many reasons:

• In many countries gold continues to be an integral part of social and religious customs, besides being the basic form of saving. This continues to be exceptionally true in India, which is the world's largest consumer of gold. Shakespeare called it 'the saint-seducing gold'.
• Superstition about the healing powers of gold persists. Ayurvedic medicine in India recommends gold powder and pills for many ailments.
• Gold is indestructible. It does not tarnish and is also not corroded by acid - except by a mixture of nitric and hydrochloric acids.
• Gold has aesthetic appeal. Its beauty recommends above all other metals for ornament making.
• Finally, gold is scam-free. So far, there have been no Mundra-type or Mehta-type scams in gold.

Thus, the lure of this yellow metal continues.

On the other hand, it is interesting to note that apart from its aesthetic appeal gold has no intrinsic value. You cannot eat it, drink it, or even smell it. This aspect of gold compelled Henry Ford, the founder of Ford Motors, to conclude that 'gold is the most useless thing in the world'.

The returns from gold

During the 1950s, gold appreciated only marginally; from Rs 99 per 10 gms in 1950 to Rs 111 per gms in 1960. During the next decade, from 1960-70, it moved up to Rs 184.

Between 1970 and 1980 came the massive rise from Rs 184 to Rs 1,330.

During the 1980s, it moved up another 240 per cent. The trend of gold prices in India in the last few years is given in Table 1 which reveals that between 1950 and 2007 gold appreciated 95-fold, an annual compound rate of return of 8.32 per cent.

How to buy gold

Gold Deposit Scheme

Introduced in 1999, this scheme is managed by SBI [Get Quote]. Individuals, HUFs, trusts and companies can deposit a minimum of 200 gm of gold with no upper limit, in exchange for gold bonds carrying a tax-free interest of 3 to 4 per cent depending upon the tenure of the bond ranging from 3 to 7 years.

Furthermore, these bonds are free from wealth tax and capital gains tax. The principal can be collected back in gold or cash at the investor's option.

Buying gold bars and coins

You can now also buy gold coins or bars/biscuits from various authorised banks and dealers. So, if you too are touched by the yellow fever, well, you could satisfy fascination by keeping some gold coins and bars with you.

Incidentally, don't be mistaken into thinking that buying ornaments is the same as investing in gold. In practice, gold converted into ornaments is rarely sold. Thus, though gold ornaments are a liquid asset their sale usually entails a heavy loss. The making charges are a total write-off. Then, too, your jeweller may take undue advantage of your predicament and buy back the ornaments at a discount.

Gold exchange-traded funds

The modern international method of investing in gold is via gold mutual funds. India should soon be catching p in this area.

In his Union Budget for 2005-06, Finance Minister P Chidambaram had proposed that Securities and Exchange Board of India should permit mutual funds to introduce Gold Exchange Traded Funds (Gold ETFs) with gold as the underlying asset.

According to the Budget proposals, the scheme would enable households to buy and sell gold in units for as little as Rs 100 and such units could be traded in the same manner as units of mutual funds.

Gold Exchange Traded Funds are a relatively recent phenomenon even in the American market where the first Gold ETF--StreetTracks Gold--made its debut in the New York Stock Exchange in November 2004. Each unit of the StreetTracks Gold ETF represents one-tenth an ounce of gold.

In Gold Exchange Traded Fund, the underlying asset is exclusively gold bullion, and not a basket of stocks as is the case of equity ETFs. Gold ETFs are shares or units of gold that are owned by investors and are fully backed by gold bullion bars held by a custodian.

Like other ETFs, they are traded on a stock exchange.

Gold ETFs will allow investors to buy gold in small increments. In the global market, one unit represents one-tenth of an ounce fine gold (1 oz-28.35 grams). If an investor in the fund holds 100 units, the fund must have physical gold worth 10 ozs.

The value of the unit will move in accordance with the price of gold. Just like mutual funds, the value per unit will be the total value of the gold held, divided by the number of units, minus the expenses of the fund. Gold ETFs, like any share, can be traded and bought by the investors through their stockbrokers.

They can be used for speculating in the short-term for betting on the price of gold, or it can be used for long-term investing. Just like the ETFs, Gold ETFs can be open-ended funds or closed ended funds.

In India, the ETF structure may be particularly suitable for a gold fund because of the unavailability of a highly liquid, organized market for gold or gold-backed securities.

Tax implications

Since there is no income as such from holding gold, there is no liability of income tax. But bullion and jewellery are subject to capital gains tax and wealth tax, without any exemptions whatsoever.

While determining the value of gold ornaments for the purpose of wealth tax, making charges should be ignored, unless the ornaments are studded with precious stones. The value of gold contained in the ornaments can be reduced by 15 to 20 per cent because the dealer invariably deducts 15 per cent of the ruling rate of standard gold when ornaments are sold in the open market.

The prospects for gold

Many contemporary investors forget that when gold price went up during the late 1970s, the metal was just trying to catch up with prices of other things, which had already gone up.

In 1970, when the price of gold was $35 an ounce (due to the gold standard then followed in usa), it was unquestionably undervalued. When gold hit $850 an ounce in January 1980 it was again, unquestionably, overvalued.

If the increase in gold price had kept the same pace in 1980s and 1990s as it did in 1970s, it would have become $20,000 an ounce by 2000. With a number of Central Banks selling off huge chunks of their gold reserves, the international price of gold has come down in the last few years.

Timothy Green, a well-known gold expert, reminds us of a historical truth: 'The great strength of gold throughout history has not been that you make money by holding it, but rather you do not lose. That ought to remain its best credential'.

A research study on gold established a remarkable consistency in the purchasing power of gold over four centuries. Its purchasing power in the mid-twentieth century was found to be nearly the same as in the middle of the seventeenth century.

You can safely invest in gold. But take care to keep your jewellery in bank lockers. You can also raise loans on gold for your other portfolio investments. If the Indian economy continues to be liberalised and unshackled fast, several new options may emerge for investors to invest in gold bars, gold coins, gold funds, gold mining companies and gold options.

It will also lead to the eventual equalisation of domestic and international prices.

N J Yasaswy is a Founder-Governor of the Institute of Chartered Financial Analysts of India and ICFAI Business School and has written several books on finance and investments.

• Excerpt from Personal Investment & Tax Planning Yearbook: FY 2007-08
• Author: N J Yasaswy
• Price: Rs 235/-

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