Key driver of gold in 2014: physical demand

Demand for physical gold out of China and other emerging markets has become the key driver of bullion prices, according to HSBC, as the rampant outflows from exchange traded funds (ETF) seen last year begin to stabilize.

"Investment demand, which had fueled the rally for over a decade, is no longer driving gold prices," James Steel analyst at HSBC wrote in a report on Tuesday.

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"Instead, we believe gold is being driven by physical demand for jewelry, coins, and bars from China, in particular. Indeed, we would argue that physical demand trends in the emerging world will largely define gold's price movements this year," Steel added.

Gold's 12-year bull-run ended in 2013, with prices suffering their largest annual decline since 1981 as the Federal Reserve's decision to taper its monthly asset purchases triggered heavy ETF selling.

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Investors liquidated 881 tons of gold from ETF holdings last year, reducing total holdings by one-third from their peak at the end of 2012.

While the prospect for further liquidation exists, the bulk of ETF sales have likely occurred, the bank said, forecasting ETF demand will increase by around 90 tons this year.

China 'main actor' in gold market

As institutional investors shun gold, Chinese consumers have come to the rescue, absorbing the flood of gold from the ETFs. Last year, China overtook India to become the largest consumer of the yellow metal, and the bank expects to see continued robust demand out of the mainland.

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"China is the main actor in what has become a historic physical migration of gold from western investment hands to eastern consumers," Steel said, noting that the country alone is absorbing the equivalent of half the world's gold mine production.

While the pace of gold buying in China may moderate this year from the white-hot levels of 2013, there's no reason for a notable slowdown, he said.

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As economic policy shifts from export- and investment-driven growth to greater domestic consumption, this should benefit the purchases for luxury gold items and stimulate consumption in regions where, up to now, demand has been modest, he added.

Based largely on the growing appetite for gold in China, the bank forecasts a 5 percent on-year increase in jewelry demand to 2,310 tons in 2014.

Price outlook

Nonetheless, the HSBC is leaving its price forecasts for gold unchanged at an average of $1,292 per ounce for 2014, below current levels of $1,350.

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"[We] expect a slight reduction in mine growth supply, weak increases in scrap supplies, steady central bank demand, and ongoing increases in jewelry, coin, and bar demand," he said.

On the other hand, however, Steel notes that Fed tapering, possible U.S. dollar strength, and disinflationary trends could present headwinds to further gold rallies.

—By CNBC's Ansuya Harjani. Follow her on Twitter @Ansuya_H