Commodities & Futures: A roller-coaster ride for gold

GOLD'S blistering fall last week will have disappointed its cheerleaders, who may have been hoping for a return some day to the heady dollars 800 levels of the early 1980s - and upset those who lost money in the melee.

Gold closed at dollars 374.50 an ounce on Friday in London, down dollars 13.75, and a dollars 35 drop from its dollars 401 closing on Wednesday. Most of the damage was done late on Thursday, when computer- programmed US investment fund selling drove futures prices down by about dollars 23 in New York.

Yet only days before, gold had rocketed through the dollars 400 mark, the highest level since January 1991, as the exchange rate mechanism looked near to collapse in frenzied currency trading.

Why the roller-coaster ride? Has the rise been an insubstantial 'paper rally', fed by investment funds buying futures and options contracts in response to computer signals? Or does genuine demand underlie the bullish euphoria? Perhaps the answer lies somewhere in between. Two aspects of the recent gold fever deserve a closer look.

While everyone was talking excitedly about George Soros and Sir James Goldsmith investing in gold in the spring, the underlying impetus for its rise was coming from China and other developing countries.

Chinese consumers increased their purchases of gold coins and jewellery early this year as their economy expanded rapidly and the Chinese currency was floated internationally. Higher living standards put more money in their pockets, and they started to worry about rising inflation.

Traditionally, the Chinese have favoured gold as an investment. And the price was right: between January and March 1993 it fluctuated around seven-year lows of dollars 326. Perhaps not so coincidentally, gold started its climb in March, turning into the first rally in several years.

But in April, Chinese buying suddenly started tailing off. Research published by the World Gold Council last week showed Chinese demand at 57 million metric tons in the second quarter from 95 million in the first.

The rise in the gold price, a devaluation in the renminbi which slashed dollar proceeds to gold importers, and fears of further falls in the currency as the government applied the economic brakes all slowed the flow of gold into China.

Other developing markets also lost their appetite for the metal from April to June. Demand from Asia, the Middle East and Latin America slowed to 407 million tons in the second quarter from 537 million in the first, the WGC says.

The WGC believes that Chinese demand remains strong, and that when liberalisation reaches the Chinese gold market it will unleash huge potential.

A second compelling trend has to do with gold's attractions relative to other investments. Lawrence Eagles, analyst with GNI Commodities Research, believes gold rallied through dollars 400 when the ERM was on the brink of collapse because investors anticipated a round of interest rate cuts.

Lower European interest rates increase gold's appeal by reducing the opportunity cost of holding gold as an investment rather than putting your money in a savings account.

'There is much less risk now in owning precious metals because there is not the opportunity cost there was when rates were high,' Mr Eagles said.

Gold may have tumbled last week because the expected European interest rate cuts were not forthcoming. But, with reductions looking inevitable eventually, money may keep pouring into gold as a way of diversifying investor portfolios while inflation and rates remain low.

If so, the gold price will eventually pick up again, though perhaps not in a hurry.