Beyond the Bike - Gold Digging in Sudan

Faisal sells ful (Arabic equivalent of baked beans on toast) & chaai (tea) in a windswept shack on the side of the desert road in northern Sudan. In his spare time he digs in the local area for gold

Last September in Zambia, I met a jewellery designer who had just sold 3 identical & expensive gold necklaces to a Chinese businessman. 3 wives? I suspect the man wasn't buying them as presents. Maybe he was trying to avoid paying tax or simply searching for an effective store of value: the recent global financial crisis has reduced people's trust in banks & more orthodox saving methods.

Six months later, I've just finished cycling through Sudan. Whilst the gold price hasn't changed substantively in recent months, it has boomed over the last decade, rising some six-fold in nominal terms and nearly the same when taking into account of inflation. Despite recent worries, inflation has been negligible relative to the 1970s or early 1980s.

Time to short (sell) gold? In the last 2 years, it has hit record levels, in nominal terms

Along the road in the desert, I met many goldiggers like Faisal, all trying to take advantage of the soaring price. Reuters report that there are some 200,000 such people in Sudan, accounting for nearly 90% of the 70m tonnes of gold extracted in Sudan over the last 12 months.

My meetings with these men looking for a quick fix to extract them from their relative poverty have thrown up many questions. Two in particular spring to mind. Firstly, what has caused the surging price in gold and secondly, is this another example of the 'resource curse' for economies like Sudan. I touched on the latter question briefly when in Zambia which is experiencing a similar issue with Copper. So in this blog, I'm going to look at what has caused the surge in price of gold.

For students of economics, the theories of supply & demand probably spring to mind. A shift to right in the demand curve or a shift to the left in supply. Which one is more important? Well, for starters, supply is barely affected by annual production. Experts estimate some 170,000 tonnes of gold have been extracted since the year dot. Most of that still exists in an accessible form. The World Gold Council estimate annual production is a 'mere' 2,500 tonnes.

Even if these guys get rich making a big discovery, it isn't going to have much effect on the price of gold traded in London!

Total Gold ever mined could be represented by a cube with an edge length of around 20m

Thus, we need to look at the determinants of demand. Due to its nature, relative to other commodities, gold isn't consumed in the normal way. As such, we also need to consider the demand from savings. Was the Chinese gentleman buying gold to consume or save?

Either way, I'd suggest three factors are most important.

Firstly, rising incomes in the developed world. In 2009, India & China had already overtaken the USA as the largest consumers of gold jewellery, in volume terms. If consensus expectations are correct about income projects for China & India, don't expect this trend to reverse any time soon.

Secondly, gold is often seen as a hedge against financial stress, prevalent in recent years. As savers have lost confidence in the traditional paper instruments such as stocks which tend to perform well in stable political environments with strong economic growth, gold is seen as a 'safe haven' when risk aversion rises. Gold is often used as a hedge against inflation too. Whilst inflation has remained low in recent years, longer term inflation expectations have risen, driven by concerns over rising budget deficits. The worry is that governments are attempting to 'spend' their way out of the recession by effectively printing money.

No need to hit the panic button? we selotaped this headline to my boss's computer at Citi during the crisis of 2008. By the end of the year, he was out of a job (sorry Dr Rick!)

Related to my second point is the recent policy of Western central banks in keeping interest rates at record lows over a prolonged period of time. The Bank of England's base rate, for example, remains at 0.5%, the lowest nominal level in the Bank's 300 year history. Low interest rates mean that the opportunity cost of owning gold is low. When interest rates are high, you can get a return from owning paper assets like stocks and bonds. I.e. there is significant opportunity cost to holding a commodity like gold that produces no income. Not today.

Gold v Stocks since 1900. Despite its recent outperformance, it wasn't a great investment during the 20th Century

Where now for the price of gold? If I knew the answer, I'd probably continue cycling around the world on the profits of my knowledge. What I can say is this: the health of world economy & interest rates will both play a key role. If we see a recovery in global GDP prompting a rise in interest rates and a return to a more 'normal' economic environment, Faisal & his chums will be back to hoping for more bicycle tourists in Sudan hungry for ful & chai. You want to know what the next scarce commodity to invest in? If cycling through the desert along the Nile has taught me one thing, it is that we can't survive without WATER.

In search of water in the golden sands – the next commodity to invest in? But isn't it a public good?

Suggestions for using this blog with students

1) MACRO: impact/effect of monetary policy. loose policy (super low interest rates) have arguaably caused a bubble in gold prices and this has some 'unintended consequences'. (opportunity cost of holding gold in period of low interest rates for investors etc). you could also focus on effect of economic crisis global recession - lower interest rates, risk aversion etc.

good for streching brighter L6 students but relevant for U6th in general.

2) MICRO: this may not be so relevant right now but plenty of material for focus on (S&D; determinants of demand). Get them to try a wifcaps on demand for gold. It could also be something you look at before summer visit to Bank of England (if that is still the plan?) - given central bank focus on gold and the weight of a gold bar that you can pick up at the museum!