In the past year, gold prices fluctuated sharply. Starting at a high of $2,000 per ounce in May 2023, gold prices witnessed a significant decline, settling around $1,700 by December 2023. The fluctuating journey of this precious metal offers a window into the complexities of financial markets, where gold’s traditional role as a haven is continually tested against evolving economic landscapes.
Gold’s price trajectory over the past year has been anything but linear. From its peak, the decline to the current price reflects various global economic pressures, including changes in inflation rates, shifts in central bank policies, and evolving geopolitical scenarios. Looking ahead to 2024, forecasts remain cautiously optimistic. Goldman Sachs predicts an average gold price of $2,133 per ounce, a figure that stands above the consensus. In contrast, the World Bank maintains a more conservative stance, projecting a rise to $1,900 an ounce, followed by a potential stabilization or decline.
This disparity in forecasts underscores the inherent uncertainty in predicting gold prices. Factors such as global economic health, currency fluctuations, and investor sentiment play crucial roles in shaping the future trajectory of gold prices. The metal’s allure in times of uncertainty is offset by the risks associated with its price volatility.
Meanwhile, in Sri Lanka, the finance and leasing companies (FLCs) have been particularly impacted by these fluctuations in gold prices, posing risks for the financial sector, Fitch Ratings said in a December 2023 statement.
The FLC sector, traditionally reliant on vehicle financing, has seen a significant shift towards gold-backed loans. Between March 2019 and March 2023, the volume of gold-backed loans increased fourfold, accounting for 18% of all loans in the sector, up from 4%, Fitch says.
This shift is attributable to several factors. The declining demand for vehicle financing has pushed FLCs to explore more lucrative avenues. Gold-backed loans, offering short-term financing solutions, have emerged as an attractive alternative. Their popularity is further bolstered by the relative ease of liquidating gold collateral through auctions in case of loan defaults.
This growing dependence on gold-backed loans is not without its risks. The key concern for FLCs is the volatile nature of gold prices. A significant drop in gold prices, as witnessed in 2012 and 2013, could lead to a surge in non-performing loans (NPLs) and elevated credit costs. Loans with longer repayment tenures are especially vulnerable to sustained price corrections, Fitch warns.
The rating agency says the increasing competition among FLCs has led to higher loan-to-value (LTV) ratios, hovering between 70% and 80%. These high ratios pose a risk of rapid deterioration if gold prices fall or borrower defaults increase. Unlike markets like India, where regulatory caps exist on LTV ratios for gold-backed lending, Sri Lankan regulations offer no such safeguards.
Sri Lanka’s regulatory capital rules have inadvertently encouraged FLCs to expand their gold loan portfolios more rapidly. Gold loans with LTV ratios up to 70% do not incur any risk weight under current regulations, implying that only incremental exposure above 70% is considered risky. This contrasts sharply with the Indian market, where gold loans typically incur a standard 100% risk weight.
The drop in local gold prices in the first quarter of the financial year 2024 led to an increase in the risk-weighted share of gold loans, but this was expected to reverse as gold prices recovered. This regulatory framework potentially leads lenders to underestimate their risk exposure, leaving them inadequately capitalized to absorb potential shocks.
Fitch notes that in assessing gold-backed loans, Sri Lankan FLCs focus solely on the collateral value, rather than the borrower’s repayment capacity – a practice that diverges from other markets. This approach puts a premium on accurate gold valuation, a process that varies among lenders in Sri Lanka. The lack of standardized valuation methodologies further complicates the scenario.
Despite these challenges, the rate of NPLs in gold-backed lending has traditionally been lower than in other lending types. This is largely due to the ease of recovering debts through gold auctions. Borrowers often opt to roll over their loans at maturity, paying only the interest. However, the recent economic environment has strained this model, Fitch says. The ratio of gold loans overdue by more than 90 days among Sri Lankan FLCs rated by Fitch jumped to 5.3% at the end of 1QFY24, up from 1.9% at the end of FY22. This increase aligns with the growing volume of gold auctions, indicating a rise in defaults.
Gold’s historical reputation as a stabilizer in times of economic uncertainty is weighed against its recent performance. While some analysts remain optimistic about gold’s future role, especially in light of ongoing economic uncertainties, others point to the metal’s volatility as a cause for concern.
For investors and analysts, the divergent forecasts for gold in 2024 present a complex picture. The cautious optimism from some quarters is tempered by the more conservative outlook from others. The Sri Lankan experience, particularly the challenges faced by its FLCs, offers a microcosm of the broader issues at play in the gold market. It underscores the need for a balanced approach in assessing gold’s value, both as an investment and as collateral.
The journey of gold prices and their impact on financial institutions like Sri Lanka’s FLCs is a testament to the complexities of the global financial system. The precious metal continues to hold a unique position in the world of finance, attracting attention and debate. As we move into 2024, the only certainty is that gold’s path will be closely monitored, with each twist and turn offering new insights into the ever-evolving dynamics of financial markets.