Mining’s old guard needs strong medicine
A new report details subpar investor returns in the mining industry over the last decade, particularly big cap diversified companies which have not adapted to new realities.
Shock and Awe
India’s gold imports in August were shocking! Although reports vary on the actual amount, with many news outlets reporting 2.5 tonnes while some are reporting 3, the difference obviously doesn’t matter.
It’s negligible when you consider that India represents the largest chunk of global demand and imported an average 72 tonnes per month in 2012.
What is equally alarming is that the Indian government finally succeeded in stifling imports after several months of trying. They probably shouldn’t pop the cork on the victory Champaign just yet, although it may warrant a beer? One month does not constitute a trend.
However, it is too important an event for the prudent to ignore. Therefore we should take some time to read the tealeaves and determine the investment implications.
Background
Let’s begin with some historical context to illuminate August’s development.
In recent Weeklies, we have extensively profiled India’s love affair with gold. We don’t want to retell the whole tale here so we’ll just say that India and gold have been soul mates for millennia and their affection for the yellow metal has not diminished with time. (If you want, visit the “India” category on our Weeklies page for more on the topic.)
On the other hand, the Indian government and their central bank, the Reserve Bank of India (RBI), have had a love/hate relationship with gold.
The hate part comes from the fact that it’s very difficult to maintain a paper currency regime when your citizens prefer gold as their store of wealth.
Usually, when Indian’s receive rupee income for their labors, they exchange a sizeable portion of it for gold. This puts pressure on the rupee because it’s sold for dollars to buy gold. Given the massive size of the Indian population and their strong propensity to save, it means that a lot of rupees are sold, which exerts downward pressure on the currency.
Our tale of the hate part of this relationship begins in 1947, which is ironically the same year India gained independence from the British.
Shortly thereafter, along with many fast and furious policy initiatives, the fledgling government passed the Foreign Exchange Regulation Act which carried the stated objective“to wean people away from gold, to regulate supply of gold, to reduce smuggling, to reduce the demand for gold, and to reduce the domestic price for gold.”
It doesn’t get more explicit than that. This legislation outlawed the import and export of gold but not the private ownership or domestic trade of the precious metal. It held sway until 1963 when the government made additional moves to tighten the screws.
They initiated what was known as the Gold Control Rules and in 1968 passed the Gold Control Act. The primary features of these new regulations were that they outlawed the ownership of gold bars and only permitted citizens to own gold jewelry and gold coins.
Now Indians certainly don’t mind owning jewelry as part of their affinity for gold. However, this new law increased its value as a store of wealth and currency on the black market. Such unofficial markets have a bad habit of springing up whenever and wherever this type of protectionist and isolationist legislation rears its ugly head.
At the grave risk of oversimplification, the madness continued until a more enlightened policy prevailed in the early 1990’s when the Gold Control Act was finally repealed. It’s at this time that the government began to liberalize the Indian economy to promote growth, jobs, and wealth.
In hindsight, these moves have proved to be prosperous for the Indian people. Much poverty and corruption remains, but there have been substantial increases in life expectancy, literacy, and of course economic growth and prosperity.
One way to measure the increase in overall economic prosperity of a country over a number of years is by GDP. And instead of writing a thousand words, I’ll just show you the chart.
Follow the path of the red line on the above chart from left to right. Beginning in 1990-91, when the economy began to open up, the journey that India has taken to greater prosperity is evident.
And what did the Indian people spend a sizeable amount of their newfound wealth on? Yes, it’s a rhetorical question. The answer is obviously gold.
As the chart shows, in 1990 Indian gold demand was just over 200 tonnes. By 2011, it had risen 5 times to 1,000 tonnes. And in 2012, it was still a lofty 845 tonnes. It’s fairly evident that as the Indian people got wealthier, they bought more gold.
Aside from their cultural affinity for it, Indians also buy gold to maintain their purchasing power. In the past as in the present, the Indian rupee is notorious for inflation.
For some perspective on Indian inflation let’s look at the value of the rupee versus the US dollar since 1991.
That’s not a comforting chart for anyone that holds rupees!
Now, let’s look at why Indians buy gold.
That’s much better!
The above chart shows that both the rupee and the dollar are losing purchasing power against gold, but the rupee is winning the race to the bottom by a large margin.
The Problem
India’s two major imports are oil and gold. Unfortunately for India, they must pay for both on international markets with US dollars. And when your currency is in free-fall, as the rupee has been since April (see chart below), dropping approximately 20%, these imports get really expensive!
One of the primary catalysts for the Rupee’s plunge has been India’s surging appetite for gold. In order to feed the country’s insatiable appetite for the yellow metal, importers must sell rupees for dollars in massive quantities putting strong downward pressure on the currency. This in turn depletes the central banks US dollar reserves.
This is a serious issue because without US dollars, how do you pay your enormous oil bill, or other critical commodity bills, on the international market?
When you combine the factors of a falling rupee, rapidly declining US dollar currency reserves, and the substantial imports of oil and gold by India, they equal the third largest current account deficit in the world. At the end of August, the deficit was approaching US$90 billion. This is what you might call aproblem.
In the desperate search for a solution the Indian government has beat a panicky retreat to their protectionist roots and decided to aggressively suppress gold imports…again.
The Solution in Action
It all started on Jan 21st of this year with a meager 200% increase in gold import duties and a disingenuous message from the Finance Minister stating that there were no further plans for additional taxes on gold imports.
A month later, he was pleading with the Indian people to stop buying so much gold. His plea fell on deaf ears. In April, coinciding with the mysterious gold price swan dive ignited on the US futures exchange, India imported an eye-watering 141 tonnes of gold. They then followed that performance with a dizzying 162 tonnes in May!
It’s hard to overstate the sheer scale of this wave of demand over the course of just two short months, but the imagery of a Tsunami comes to mind. It must have set off alarm bells in the halls of the central bank!
Realizing that the Indian people mistook his admonishment not to buy gold as a secret signal that they should buy gold in record amounts, he promptly raised the gold import duty another 2%, to a total of 8%. Then, in July, the RBI tried a new tactic issuing a rule requiring importers to re-export 20% of what they import; the so-called 80/20 rule.
In August, the Finance Minister made a declaration that India will hold gold imports to under 845 tonnes for the year. Backing up this proclamation he raised the import duty yet again, by another 2% (now at 10%), banned the import of coins, and cut off domestic buyers’ ability to buy gold on credit.
“There…that outta do it!” – The Finance Minister said while stroking his hairless cat.
The Outcome
August Imports = 2.5 tonnes.
Several reports have indicated that the reason imports were so low is that importers did not understand the restrictions, and therefore were uncertain how to comply or whether it was profitable to do so.
Regardless of the reason, the fact remains that imports dropped 95% from the previous month! Or perhaps the right way to say this is that they were effectively shut-off. Anyway we phrase it, we have to acknowledge that the government’s efforts to suppress imports were successful in August.
There has been plenty of news since mid-August suggesting that the confusion over the new rules has been resolved and that imports will resume again soon. However, we have yet to see any confirmation that this has happened.
As prudent market observers, these developments in the world’s top gold consumer require our attention. This is because, if the central bank can succeed in August, they could potentially extend the blockade through September, and then the month after, and perhaps for many months to come.
Although discouraging, we shouldn’t lose sight of their history with such things.
The Gold Miners Crystal Ball
We know that our message this week is tough medicine to swallow but investment success requires regular reality checks and sober-minded judgment. Therefore, we’ve done our homework and put a lot of thought into this week’s missive. And now, we’re prepared to tell you what we honestly think.
There is no denying that the RBI has declared war on gold. Our recap outlining the restrictions put in place since January demonstrates that they are committed to controlling gold demand by suppressing imports. They have also publically stated their intention to limit the amount of gold imports for the year to less than 845 tonnes.
So far in 2013, by compiling World Gold Council statistics, India has imported 616.5 tonnes of gold. This is a record amount of demand, even for India. In order for the RBI to achieve their stated goal of keeping imports under their stated target of 845 tonnes, they would have to limit imports to 228.5 tonnes for the remaining 4 months of the year.
And not just any 4 months, but the 4 months of the year that usually see the largest aggregate buying from arguably the world’s biggest gold buyer. Typically 40% of India’s annual gold demand is bought during the festival season that has just begun. (For more on gold’s seasonality see last week’s commentary)
Given India’s reliable seasonal gold buying history, limiting imports during this time is a pretty tall order for the RBI to execute. But given their success in August we can’t rule out the possibility that the government could achieve some or all of their stated goal.
Now before you grow despondent dear reader, hear us out.
There is a saying, often uttered by contrarian investors, that you should always assume the opposite of what a central bank says they are going to do or how they view the economy. This makes good sense.
It’s not as if a central bank could announce to its citizens, “we’re broke, sell our currency, our bonds, and buy as much gold as you can, while you can”, even if it were true. This statement would foreseeably cause a fair amount of panic.
Therefore, we must assess what a central bank is saying and discern whether they really do intend to carry out their publicly stated strategy or are just posturing.
In this case, it’s reasonable to conclude, given their history and recent success, that the RBI is committed to limiting gold imports. They must believe that they can reverse their current account deficit by suppressing gold imports.
For these reasons, we think that it is prudent to acknowledge the possibility that there could be a potential drop in the demand for gold in the short term if the Indian government were to successfully extend the current import embargo into the fall buying season.
By how much might gold demand fall as a result? Oops! Our crystal ball just fogged up. What a terrible time for that to happen.
Don’t misunderstand; we remain steadfast gold bulls because historic Indian demand is very real despite the central banks efforts and the massive global supply and demand imbalance that continues to exist in the gold market.
However, in light of the August import data out of India as a result of RBI gold policies, we think one should proceed with caution and remain observant over the short-term from a risk mitigation standpoint.
We actually see this as a potential buying opportunity should this thesis play out and the price of gold falls due to the absence of India’s demand from the market.
Further, we think that if there is another decline in the gold price, China will be happy to step in and buy in-size on the cheap. As our readers are well aware, they are also reporting unprecedented demand this year. There is no knowing for sure just how much of India’s demand they could absorb but it’s a safe bet they’ll take some of it.
Moreover, when you suppress something, especially if it is desirable, people will do whatever is necessary to obtain it. Should Indian imports remain suppressed, we think the domestic gold price and gold premiums will skyrocket in rupee terms, as they have in the past under such circumstances.
This will also cause the black market to mushroom once again and ignite larger-scale gold smuggling, as it will be an extremely profitable proposition. This is well-traveled ground for Indian gold buyers and smugglers.
And when the government is forced, likely by their gold thirsty citizens, to open gold imports up again, the Indian appetite will be enormous, and demand could be similar to the buying trend of 1990.
However this situation resolves itself, we will be monitoring it closely for our readers in future posts.
To sum up this sordid tale, in the short term anything could happen. And in the short term, we see the potential, although hardly an absolute certainty, for the RBI to successfully stifle gold imports. If so, it may cause the price of gold to ease. If this happens, it sets up an excellent opportunity to buy on short-term weakness and hold for large future gains.
This is where our Comparative Analysis Table comes in handy. It provides many important metrics critical to evaluating and comparing gold mining companies (see below).
Its purpose is to help discerning investors separate the wheat from the chaff and thereby profit from strong producers that are poised to leverage a rising gold price. In this context, we also publish a Model Portfolio for subscribers to the newsletter.
That’s it for this week and thanks for reading.
Regards,
RJ Wilcox
