Gold needs a miracle.

Gold has fallen below the psychologically important price of $300 per ounce. This once all-important metal is now regarded as the bottom of the pile in terms of investment, but it still continues to be the ordinary person's favourite item of jewellery. Can it make a recovery?

As the new year begins, the gold mining industry finds itself at a critical period in its turbulent history. Prices are below the psychologically important barrier of $300/az--the lowest point in over a decade.

Ironically, gold consumption is rising. Gold demand in the markets monitored by the World Gold Council, which account for almost 80% of global offtake, rose 11% during the first 9 months of 1997 to 2,191 tonnes, led by strong growth in India, where demand reached a record level of 535 tonnes, and the Middle-East. Around 80% of gold demand is related to jewellery consumption, and two-thirds of fabrication demand is from Asian countries, with India as the largest single market. Gold buying tends to be "price-elastic," and hence jewellery off take will increase as its price falls.

Turning to the supply side, despite a 15% year-on-year fall in the average US$ gold price in 1997 to $331/oz, mine output continued to rise. The CPM Group (New York) projects a 1.7% increase in newly mined gold to 1,947 tonnes, with the total gold supply, including scrap recycling, estimated at 2,802 tonnes. Total fabrication demand is projected at 3,076 tonnes. Thus on CPM's analysis, the supply deficit will be filled by a combination of producer hedging, private sales, and further disposals by central banks from their stock pile.

Last year, gold had completely lost its lustre. Its investment status, once seen as an instrument of financial security, was tarnished. As Mr Eddie George, governor of the Bank of England put it: "Whereas gold used to be seen as a good asset, it is now seen as the bottom of the pile."

The steep corrections in global stock markets since the last quarter of 1997 have not led to a major rush into bullion (interestingly, during the crash of 1987, the gold price rose from $400 to $500).

So what has caused this enormous change in attitude? Probably a combination of factors including expectations of more central bank sales, aggressive short-selling by hedge funds, producer hedging, mostly by South African and Australian mines, as well as the recent flight into quality US and European government bonds amid financial turmoil in SE Asia.

Central bank gold reserves have been gradually declining since the 1980s, but the process has recently accelerated. CPM Group estimates net central bank sales of 544 tonnes in 1997, compared with 311 tonnes in 1996. Governments in the Netherlands, Canada, Argentina, Australia, and Belgium have been among persistent sellers in recent years. But central banks and international financial institutions such as the IMIF and The World Bank still possess between 35,000 and 37,000 tonnes in their vaults -- representing 15-18 years' global mine production at current levels. Around two-thirds of total official reserves are held by five countries: the US, Germany, France, Switzerland and Italy. The big five holders have so far refrained from dumping their reserves, although there are speculations that the Swiss National Bank may sell up to 1,400 tonnes, over half its gold reserves, over the coming years.

There could be further official sales, especially by European Union countries, as the 1999 deadline for European monetary union approaches. The new European Central Bank, which will be established in 1999, is expected to hold only limited reserves of gold. This, in turn, could encourage the EU's other central banks, holding about 12,000 tonnes, to dump more gold onto the market.

It is not surprising that most central banks are keen to reduce their gold stockpiles, since alternative financial instruments are more commercially viable. Gold is largely a non-performing asset in an increasingly sophisticated investment era. Since the mid-1980s, gold has yielded the poorest return of any financial asset, while bond and stock prices have surged.

On Merrill Lynch's analysis, returns on bullion were negative (falling 28% in value) over the past decade, compared with positive returns of 266% and 174% respectively on the US stock market and long-term US treasury bonds. Central banks have reinvested proceeds from gold sales into interest bearing assets, such as high quality treasury bonds, where yields are far higher compared to bullion lending of 1-2% p/a. A recent analysis from UBS shows that if all central banks' reserves presently invested in bullion were transferred into foreign government bonds, central bankers would earn in excess of $20bn per annum.

In addition, gold is less liquid than foreign currency or short-term fixed-income assets, and hence cannot be easily deployed to support Forex intervention.

Some US hedge funds are taking advantage of a bear market, and have engaged in aggressive short-selling to make quick profits. Speculative short positions mean selling gold which hedge funds do not own in the expectation that the fund can buy it back at a lower price before having to deliver. This heavy forward hedging by gold companies has also led to weaker gold prices by increasing the market supply. According to Gold Fields Mineral Services (GFMS), forward sales and option hedging by producers added 192 tonnes to the gold supply in the first half of 1997.

Hedge cover for miners

At current low prices, almost no gold mines world-wide are showing accounting profits, although producers, including those in southern Africa and Ghana, are protected to some extent by sensible hedging. The average South African mine's output is hedged four years forward, and the average price received by South African producers in the third quarter of 1997 was $362/oz, which is above operating costs of $312/oz, the highest in the world. Ashanti Goldfield Ghana hedging strategy has defied the slump in price. In 1997, AGG achieved an average selling price of $450/oz, $119 above the average spot price of $331. About 80% of Ashanti's output in 1998 is hedged at $428/oz.

However, if prices struggle on the lower side of $300-$285/oz for much of 1998 then serious production cuts are likely. New investments in gold exploration and mining could be affected in Mali (where the medium-term output target is 30 tonnes), Guinea, and Tanzania. Rudolf Wolff, the London based metal broker, has estimated that almost two-thirds of South Africa's 30 mines are commercially unviable when the gold price falls below $318/oz. South Africa's gold mining industry, where output in 1997 is estimated at 500 tonnes, is now entering a new competitive phase that makes further mergers and cost-cutting inevitable. A prolonged depression in the gold industry could cost around 100,000 jobs, or one-third of the industry's total.

The futures markets are also signalling pessimism. Price weakness could persist for the next year, and the average spot price may hover around $310-$300. Merrill Lynch also envisages prices "moving in a sideways to lower price trend for some years to come." The bank cites three underlying reasons for the continuation of a bear market: an acceleration in central bank selling, especially in Europe; increased producer hedging, in any price rallies, and hence an opportunity for locking future profits; and deflation and recent steep devaluations across SE Asia -- the major area of gold consumption. The vast depreciations of the Asian currencies vis-[grave{a}]-vis the dollar since the second half of 1997 have increased the local price of gold, which could well undermine demand in the region.

Gold bulls are in a minority though some analysts see prices recovering to between $330-$350/oz towards the latter part of 1998, underpinned by robust jewellery and electronics off-takes, and a further increase in the supply deficit, as a weak price forces the closure of high-cost mines.

The global economic environment in 1998 will not be conducive to a gold come-back, as deflation is more probable than inflation. Short of a miracle, gold could only rally amid concrete signs of inflationary pressures within the G7 leading economies. This would lead to higher interest rates, and hence trigger fund liquidation out of bonds and equities. But such a scenario is unlikely for the next two years at least.

Diamonds take a beating

The plunge in consumer confidence in SE Asia and Japan has also hit the diamond market. The South African group De Beers reports that total sales were down 4% in 1997 to $4.64bn, compared with a record $4.83bn in 1996. The most significant figure was the 40% collapse in sales from the first half (reported at $2.88bn) to the second half, reporting results of $1.76bn.

Demand for polished diamonds in SE Asia, which in 1996 constituted 17% of the world's market, had almost dried up, whilst retail diamond jewellery sales in Japan, which account for 30% of world sales, fell 20%. Like other precious metals, diamond is priced in US$, thus recent depreciations of the yen and other SE Asian currencies are making diamonds more expensive, hence hurting consumption. However, consumption in the US remains buoyant, and recovery is continuing in Europe. But subdued markets in Asia will probably lead to lower sales of rough diamonds during the first quarter of 1998.

Koreans give gold to save economy

In an effort to beat the worst economic crisis of modern times, patriotic South Koreans are selling off or donating their personal gold jewellery. As in most Asian countries, gold enjoys an almost sacred status -- both as a store of wealth and as a symbol of purity. Weddings without gold rings and gifts of jewellery are unthinkable and virtually every single family owns at least some items made from gold.

It is estimated that gold held by ordinary Koreans amounts to more than 2,000 tonnes, worth over $20bn. Following appeals to the public to come to the aid of the heavily indebted country, Koreans have been lining up to sell off their treasures. Sports, television and film stars have taken the lead and in the first two days of the campaign, had donated 350oz, worth around $105,000.

Koreans have also responded to their government's call to hand in dollar bills and in less than a week, had raised more than $970m.