Central Banks and Gold

A Trend Towards Currency Blocs

Unlike in Europe, national currencies will not necessarily soon disappear. And banks such as the Bank of Canada and the Bank of Thailand will continue to look after domestic monetary policy. But their principle external role will be reduced to managing the cross-rate of the Canadian dollar and the baht against the US dollar and the yen respectively. The dominant central banks - setting overall monetary policy for the Bloc - will be the Feel and the Bank of Japan, respectively.

In other words, present trends suggest the central bank community is evolving into a small group of ‘dominant' central banks (such as the ECB, the Fed and the Bank of Japan) and a large group of 'satellite' central banks (including the Bank of Canada, the Bank of Thailand, etc.).

Central Banks Will Need Fewer Reserves

What does this mean for reserves, and gold reserves specifically? In short, central banks will need fewer reserves. 1n today's international monetary system reserves simply allow a central bank to buy its own currency in the foreign exchange market, thereby enabling a country to stave off currency devaluation. Sometimes this is desirable. More often it isn't, and central banks are beginning to realise this.

Note that the ECB chose not to stop the euro from weakening over the spring and summer this year. Why? For one thing, the European economy was weak, and a weaker euro stimulates exports. For another, there is a historic policy bias in Europe to stop a domestic currency from rising, but not falling, against the dollar. (To stop a currency from rising, the central bank sells its own currency and buys US dollars, thereby adding to reserves). The ECB may, in fact, never need to call on the remaining reserves of its members. A 50 billion euro reserve pot, of which the US dollar makes up the majority, may well prove to be more than sufficient for any eventual intervention the ECB might reluctantly decide upon.

The Role for Gold is Diminished

ls there a role for gold in the emerging central bank system? Probably not in the reserves of the satellite central banks. The Bank of Thailand will in future need some yen in order to support the baht against the yen; the Bank of Canada likewise needs US dollars, but neither needs much else. Indeed, 'satellite' central banks have little direct need for large reserve balances and little direct use for gold. (The Bank of Canada, as one of the early, true satellite central banks, figured this out a long time ago. It started selling gold in 1980 .) 'Satellite' central banks will in future borrow the reserve currency from their respective dominant central banks as needed. And they will adopt a policy of greater exchange rate flexibility, which lessens the overall need for currency reserves. (The Asian Crisis has taught a number of Asian countries not to fix their currencies too firmly, in fact, and to focus in future more on the Yen .)

There is, however, a use for gold in the reserves or dominant central banks. The ECB, for example, has little choice but to hold US dollars and yen, the two other dominant currencies, in its reserves. The first argument in favour of gold is, therefore, one of portfolio diversification. Since gold and the US dollar are negatively correlated, a reserve portfolio is more efficient with gold than without it.

There is a second, political argument in favour of gold for these central banks. Trade frictions, indeed future economic wars, will be fought between the dominant economic powers, so a dominant central bank may decide to hold more gold in its reserves and less of the other dominant currencies. Gold, after all, is not another dominant central bank's liability. It is this argument, I believe, which underlies the US reluctance to even consider selling gold. This is also the heart of an argument that China should hold less of its reserves in US dollars and at least three to four times more gold in its reserves (an argument which surfaced in China last year).

If the ECB's formula of 15% gold reserves were adopted by the Bank of Japan and the Peoples Bank of China (due to become a dominant bank by virtue of the size of the domestic economy), 3,400 and 2,700 tonnes of additional gold would be required by each respectively. While a significant amount, it is less than the nearly 16,000 times of gold in 'satellite' European bank reserves that is potentially 'excess'- plus all the gold in satellite central bank reserves in Asia and Latin America (see Table).

To be sure, some small central banks have bought gold - Poland is one. The National Bank of Poland may not be prepared, yet, to accept satellite status to the ECB. But this will change in time. With the Bank of England signalling its desire to hold fewer gold reserves (in preparation for its satellite status to the ECB?), it is difficult to imagine central banks of minor economies remaining totally outside the orbit of some dominant central bank. Rather, present trends suggest that the evolving role for gold in central bank reserves comes down to the role in 'dominant' central bank reserves only - for reasons of portfolio diversification and political independence.

The European Agreement to Limit Gold Sales

The recent am1ouncement that the ECB and 14 other European central banks will limit their gold sales to 400 tonnes - and cap their lending activities - does not change the conclusions above. Indeed, the statement might even be interpreted as confirmation of the need to lower gold reserves. Furthermore, Gold Fields Mineral Services Ltd. has estimated that western central banks sold an average of almost 350 tonnes of gold per year over the last 10 years. And IMF data suggest that the euro area has sold an average of about 240 tonnes per year over the last six years. Limiting European gold sales to 400 tonnes over the next five years would, therefore, appear to ''lock-in" a trend already firmly in place, if not also raise the amount of gold to be sold each year.

That is not to say that the Agreement was not welcome, of course. It removes the possibility that first one, then another, and then yet another central bank rushes out to sell gold before the price sinks yet further. I don't need to remind the reader just how depressed the gold price was in the wake of the UK announcement to sell gold. The UK was not expected to sell gold; if the UK decides to sell gold which country is next? Germany? The Agreement cut through this negative speculation; regardless of which country might follow the UK (and Switzerland), total gold sales would be limited to 400 tonnes per year.

Indeed, the gold market can handle 400 tonnes of European gold each year. We estimate that the price of gold can comfortably move into the low $300's, despite what on the surface would appear to be an agreement for a modest increase in European central bank gold selling. The danger to the market was uncontrolled selling from Europe, where most of the official gold resides. The danger has been contained (Table I shows that there are only about 3000 tonnes of gold outside the European area, the IMF and the BIS that could potentially add to the 400-tonne limit.

Provided that the Agreement is rolled over every five years, the selling of gold by the world's satellite central banks need not worry the market unduly. Depending upon the macro-economic environment - inflation, the U.S. Dollar, etc. there will be a gap between basic supply and demand at gold prices below S400. Mine supply is simply unable to keep up with the demand for gold jewellery. Some form of above-ground gold supply is accordingly required if the price of gold is to be kept below $400.The wealth that will be created in the world over the next generation means that demand for gold products will inexorably rise. Satellite central banks can thus ensure themselves of a decent price for their gold over the next 20 to 30 years, provided they take that long to sell their gold reserves.