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The Relation Between Gold Price and Demand for Gold Loans

The Relation Between Gold Price and Demand for Gold Loans

gold loan

In the Covid-19 pandemic time, several borrowers are taking gold loans to increase their cash reserve. The demand sees a boost with the price hike of yellow metal. This helps the borrowers to receive a higher loan amount for the same quantity and quality of gold. Also, the Reserve Bank of India (RBI) has now allowed the LTV (loan to value ratio) on gold loans as up to 90% for banks.

LTV is the percentage of loan amount that the lender can offer borrowers. This amount is based on the gold value that the person provides as security. For NBFCs (non-banking financial companies), the LTV on the yellow metal is up to 75%. The lender can allow prepayment, if the LTV goes beyond this limit. Together with price hike and increase in LTV, we can say, demand for a loan on gold has seen a rise as well.

In the following post, we will talk about the reasons for the initial high demand for gold loans in the Coronavirus period. We will discuss the factors that decide the price of gold. We will also talk in detail how the changes in the price of yellow metal influences the demand for gold loans in India.

Reasons for High Gold Demand in the Early Covid Pandemic Era

We saw a constant rise in gold prices in the early period of Coronavirus pandemic. Here are the reasons for the same:

  1. Safer Investment

Several economic stimulus packages were announced by the government. This was with an intention to create more liquidity in the market. Also, the Reserve Bank of India (RBI), came up with a norm of moratorium on loan repayments. So, several investors thought it was better to invest in gold with the falling interest rates on other investments. Also, the stock markets were volatile.

  1. Hike in International Gold Prices

The gold price in India sees a heavy influence by the gold’s international price. Due to the rising number of Covid-19 cases around the world, global economic slump, and an increase in US-China tensions, the price of the previous metal saw a hike in the international market.

  1. Currency Exchange Rate

Since the lockdown, there has been a sharp decline in the Indian Rupee. Thus, the fluctuation in the exchange rate also impacted the gold price. With high gold imports on a high exchange rate, the price of the precious metal also increases.

Change in Gold Price and Impact on LTV and Gold Loan Amount

After the initial hike in the price of the precious metal, the gold price gradually stabilized. The fall in prices, lead to several outcomes. It is important to note that as the gold price falls, then the amount available for a person to borrow also decreases. For an existing borrower, the bank may ask for a part prepayment on the loan amount. But this is likely only if there is a substantial correction in the price of the yellow metal.

Here is a detailed explanation on the probable outcomes:

  1. Part-prepayment: In case of a demand loan, the lender at any point of time, can request for a part-prepayment. This is a possibility when the LTV rises due to a correction in gold price.
  2. Additional Collateral: Or the lender can also ask the borrower to submit additional collateral. This in the view of bringing the loan-to-value ratio to a desirable level.

The financial institution may consider the past one month’s record to arrive at the gold value. They may analyse the current price or the moving average price, whichever is lower. This step assists the lender to take necessary precautions for any short-term fluctuations in the gold price.

  • Higher LTVs mean a higher risk for NBFCs and Banks.
  • This is why they limit the loan-to-value ratio to a lower level.
  • For instance, the limit on gold value for a loan is 90%.
  • Here, the bank may only provide finance up to 80% or 85% for short-term loans.
  • The LTV may fall further, say 75% or less in case of longer tenures.

Illustration: During the surge in gold price, the value of gold collateral was Rs. 2 lakhs. The bank provided Rs. 1,60,000 to the borrower. Thus, the LTV was 80%. But if the yellow metal’s price fell to Rs. 1,90,000, then the LTV reflected 88.88%. In such a current scenario, the bank may request the borrower to provide additional security.

Or, it may even ask for part-prepayment to bring the LTV back to 80%. The decision that the bank takes will depend on several factors. This includes the remaining tenure, outstanding due, relationship of the customer with the bank, etc.

Decision of the Bank in Case of Drastic Fall in Gold Price

Taking a call or asking for additional collateral or pre-payment are not the primary choices for lenders. They usually take sufficient measures by keeping viable margins when approving the loan. Nonetheless, if necessary, the bank may reserve the right to recall the loan if the gold price falls drastically.

  1. Short Term Loan: For short-term loans with tenure less than a year or so, fluctuations in precious metal price may not force the banks to exercise this option.
  2. Long Term Loan: But, for long-term loans, if a loan is booked at a high LTV, there could be a cash call from the lender. On extraordinary lowering of gold price, the borrower may have to make partial prepayments. This is again to ensure that the LTV stays within the specified limit as per the loan agreement.

Implications of Fall in the Gold Price for Lenders

For lender, a fall in yellow metal price can mean two things:

  • The financial institution has to carefully consider their asset coverage possibility.
  • Based on this, they have to determine how much margin to maintain.
  • This is especially for borrowers whose asset cover goes below the LTV norms due to gold price fall.
  • The bank may have to monitor the gold loan policy.
  • It may have to set the LTV at a lower level if the price of yellow metal is expected to fall further.

Those taking a new loan on gold, the lowering of asset price means the borrower will also receive a lower amount. The borrower will get a lower funding based on the LTV and the gold’s current price. Also, if the price tends to fall often, then the bank will also draw a more cautious measure to set the LTV at a lower level.

Factors Affecting Gold Prices

A fall in yellow metal’s price and LTV affects the demand for gold loans. But which other factors actually influence the gold price? Here is all you need to know:

  1. Inflation

The value of currency decreases with an increase in inflation. Gold price is usually not affected by inflation. Rather, may people invest in this asset as other investment options may not provide high returns during inflation. The yellow metal is thus a hedge against inflation.

  1. Demand and Supply

If the demand for gold rises, the price of the yellow metal also increases. Every year, the gold mined is not very high. This is because gold is not a consumable product. Any amount of yellow metal mined in the world, is still available. So, the supply of it is also relatively scarce.

  1. Currency Fluctuations

Gold is traded in USD for the international markets. So, when India imports gold, the USD rate is converted to INR. Thus, fluctuations in the INR or USD will influence the import price of the yellow metal. In turn, this will also affect the selling price of the asset.

  1. Import Duty

India is one of the top consumers of gold. It however contributes less than 1% of the total global product of this precious metal. Thus, the country imports a majority of gold it requires to meet the demand of citizens. Thus, change in import duty of India for gold will play a role in the selling price of this metal.

  1. Jewellery Market

During weddings, festivals, and religious functions, the demand of gold is at the peak. During this period, the price of yellow metal also sees a significant boost.

  1. Government Reserves

The Indian government has gold reserves. And as per the government’s policies, it can sell or buy the precious metal through the RBI. The gold price is thus influenced on whether the government sells or buys more.

  1. Interest Rates of Other Investments

When the interest rates on other investments fall, people may rather invest in gold if the offered returns are greater than the said alternatives. The price of yellow metal moves as per the fall and increases in the other investments’ rates. When people purchase more gold, the price and demand of the precious metal also rises, and vice-versa. Thus, the asset shares an inverse relationship with the interest rates.

To Conclude

The economic slowdown due to Covid-19 pandemic had a firm effect on gold and other investments. As investors sought safer investments, gold was the primary choice. This led to an increase in the price of gold initially. During this period, borrowers took on gold loans more than any other kind of loan. This was because the loan-to-value ratio on gold proved to be higher. Thus, borrowers received a higher loan amount.

Gradually, the world came to terms with the pandemic situation. Normalcy resumed in daily life. Even presently, every country is working around ways to resume the financial activities to recover their economy. With this, the gold prices which were at peak in early Coronavirus time, came down eventually.

Though the price of yellow metal sees an up and down even today, the same is not at such a peak as earlier. Thus, the existing gold loan borrowers may have to provide more security to the bank. Or, they have to make prepayments to bring the loan-to-value ratio as per the conditions mentioned in the loan agreement. With changes in gold prices, it is to be seen how the demand for gold loan fluctuates henceforth.

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