What determines the gold-silver ratio?

May 21st, 2009

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Our loyal readers will know that we wrote extensively on gold. In contrast, we seldom mention silver. So, we will be devoting some time on silver in the coming days.

First, as we wrote in A brief history of silver and bimetallism, both gold and silver functioned as money in most of history. Historically, each unit of gold were priced as 12 units of silver on average. There were variations across different regions and time period. For example, in Ming Dynasty China, the gold/silver exchange rate was 1:4 while in ancient Egypt, it was 1:1. But overall, the ratio was 1:12. As we wrote in The behaviour of silver and gold prices,

During the 20th century, the ratio was at an average of around 1:47, from a low point 1:38 in 1910 and 1:101 in 1990. Currently, it is at a ratio of 1:49 [March 2008].

Today, the ratio is at 1:66. It even reached past 1:70 recently.

Gold and silver prices track each other very closely. As we wrote in The behaviour of silver and gold prices,

Since 2001, silver and gold prices have been consistently moving together at a correlation of 0.98 (0.00 means completely no correlation and 1.00 means perfect correlation). Though they tend to track each other, the ratio between them tends to vary.

So, why did the ratio moved from 1:47 in March 2008 to 1:66 today?

To understand why, we must first understand the nature of silver. Silver is viewed as a monetary asset in the same way as gold. From this perspective, both gold and silver are monetary relics from the past. But for silver, it has broken from the past. Unlike gold, silver has much more industrial use. In fact, it is said that silver is the indispensable metal as scientific discoveries in the 1960s saw the widespread industrial applications of silver. Here are some examples of silver usage: batteries, bearings, biocides, brazing catalysts, coins, electrical conductors, electronics, electroplating, jewellery, medical equipment, mirrors, reflective coatings, photography, silverware, solar energy cells, soldering and water purification.

The short-term correlation between gold and silver prices are due to the market’s view of  both of them as monetary asset. But the variations in their exchange ratio are probably due to the industrial demand for silver. This is most obvious in the second half of 2008. As the global economy fell off the cliff in that year, industrial demand collapsed, driving base metals and asset prices to the floor. At the same time, the gold-silver ratio shot up. Over the past couple of months, the ratio drifted downwards.

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