Gold and Central Banks: A Change in Attitude

Principal Trends In The Gold Market During 1996

As indicated in the Gold Fields Report

• The year was dominated by the intense interest in the future development of European official gold reserves. Fear of large-scale official sales gripped the market for much of last year and played an important part in driving clown the gold price. Rumours about new sales were very important, even though on a net basis official sector sale came to "only" 239 tonnes in 1996, close to the average level of net sales for the last 10 years of 213 tonnes.
• Mine production grew at the fastest rate since 1992.
• A series of official transactions and statements ensured that any positive sentiment in the gold market would be short-lived.
• In March, Belgium announced that it had completed the sale of 203 tonnes of gold "with another central bank."
• Throughout the year, discussions took place at the IMF about the possibility of selling 5% of its gold reserves in order to aid some of the· most heavily indebted countries.
• The Swiss National Bank can now, see a change in its previously passive policy on gold.
• During the fourth quarter, the Netherlands sold 300-tonnes of its reserves, as had been announced in early January 1997.
• New York investment funds sold short heavily.
• There have been none official purchases on a world­ wide basis since 19 88 and, bar hoarding, a major component of demand at the end of the 1980s, had declined by last year to only 5% of the total demand.
• On the official purchase side, two countries were prominent: China and Russia. It appears that most of these purchases were done with the objective of portfolio diversification, especially in the context of huge inflows of foreign exchange in recent years.
• The investment interest declined during the year. The sharp fall in coin and bar hoarding demand showed a clear circular relationship between the falling price and the lack of investment interest, with the perception of falling prices encouraging short selling and the resulting sale of borrowed gold pushing the price down further.
• Fabrication rose slightly.
• Producer forward sales appeared for the first time on the demand side of the equation as a result of a net year-on-year decline on forward selling positions.

In their wish to forecast future movements of the market, analysts are continuously looking at central banks. Based on past years' experiences, central banks are regarded as probable net sellers of gold.

The first issue is to recognize that they hoard too much gold and that, in this context, there are good possibilities that some of them decide to reduce their holdings.

The Size Of Central Banks' Gold Reserves

UBS has recently published a very in the resting chart that includes the evolution of central banks' gold reserves. In general, there is a reduction from 36,289 tonnes in 1960to 34,439 tonnes in 1996. Two groups were behind this reduction: the industrialised countries and Latin America (although the sizes of their reductions were quite different).

All other groups increased their holdings of gold reserves, especially Asia (excluding Japan, which is grouped with the industrialised group) and the Middle East. Figures on East Europe - although they show impressive growth - are very difficult to analyse, in that good information is not available for the first part of the period under study. It is important to point out the strong Multilateral Agencies' group growth.

It is easy to perceive that gold reserves are very large in some countries. If we relate these figures to the total reserves of each country, we see that in some cases the share of gold is extremely high. Nevertheless, sometimes the question is that many countries have undergone a reduction in their reserves (other than gold). As governments were not allowed - by law or in practice - to touch the gold reserves, the share of gold in the total has increased.

So, it is possible to conclude that there is not a pattern in the amount of gold hoarded by central banks in relation to neither the size of the country nor to their total reserves. On the other hand, it is not clear why central banks hoard gold - a matter that has been thoroughly discussed in our institution s.

Principal Reasons For Hoarding Gold

• Central banks hoard gold because they have traditionally clone so. Th.is is clearly a tautological argument, but sometimes seems the only one that will explain our holdings.
• In the past, gold was seen as the principal "reserve" of a central bank. This idea was quickly given up after the abandonment of the gold standard system. Modern central bank charters (including Argentina' s) simply state that they should maintain their reserves in liquid instruments, regardless of whether the reserves are in gold or currencies.
• People have looked upon gold as an untouchable asset for a long time. Governments (fortunately) were not able to use gold for intervention purposes, principally because it was not liquid enough.

Why Central Banks Have Started To Disregard Gold Hoarding

• Gold lost its role as a means of payment.
• Hoarding gold is very expensive.
• Gold is liquid, and therefore not available when market intervention is required.
• There are clearly other instruments offering higher returns.

Is It Correct To Disregard Gold Hoarding?

• It is true that gold is no longer used as a means of payment, but central banks maintain other assets having the same characteristics.
• Hoarding gold is not more expensive than holding other assets, Central banks can open book accounts in highly rated banks and operate them as any other account in different currencies.
• Gold is now a liquid asset - provided it fulfils the LBMA standards and is located in one of the principal trading centres and / or is booked in active commercial banks. Today, it is possible to actively tackle gold on a spot basis or by use of different derivatives in a very deep market. The market recently absorbed important amount s of gold while the operatives hardly perceived who was selling the metal. Although the price dropped, intervention by any central bank selling a particular currency would have produced a similar effect on its quotation.

Why Should A Central Bank Avoid Gold Hoarding?

The only reason to avoid hoarding gold is the possibility of finding other investments within the market that offer higher returns, Gold is not any different from other assets, and should, therefore, be treated the same as, for instance, investment in yen, pounds, or whatever. Equally, it fulfils the same purpose of diversification as any other asset.

In This Context, Is It Possible That A Central Bank Would Decide To Increase Its Hoarding Of Gold?

A central bank should only decide to increase its gold reserves if and when it has a positive outlook on the gold market. Nowadays, it is extremely difficult to maintain such a perspective. Nevertheless, if central banks currently avoid using­ economic reasons to explain why they are hoarding gold (and consequently take the decision to reduce their holding s when they have a negative view on gold), sooner or later they could consider the possibility of increasing their holdings and entering the market again.

Up to the present, the market has grown used to seeing central banks as net gold sellers. It will probably maintain this perception for some time. Nevertheless, at a certain point, it becomes possible to change that perception. If central banks, taking into account the factors of production costs and overall production versus total demand- indicators sometimes easier to forecast - consider that the prevailing price is low enough, then it becomes possible for them to once more enter the market in order to increase the share of gold among their total reserves.

This view on capital gains is the counterpart of the actual view of possible capital losses. If central banks abandon the use of extra-economic reasons to hoard gold, they can similarly employ future economic prospective to decide to invest in gold in the future.