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December 18, 2005

Gold in Central Bank Reserves - The Future - Why?
by Julian D. W. Phillips

As Gold confirms its performance as a currency and foreign exchange rates move up a gear in volatility, the subject of Gold in Central Bank Reserves is moving to center stage. Different nations construct their reserves for different reasons, usually practical ones reflecting the nation's international position in the global market place as well as for that 'rainy day' that may come.

With this in mind we look at different nations reasons for having them there as well as some postulated reasons put forward recently.

Around a year ago, as the U.S.$ came under the spotlight a very European reason for holding gold in the reserves of a nation was put forward. It was the current President of Germany's Bundesbank that described gold as a "useful counter to the swings of the Dollar". Since then and particularly recently it has become clear to all Central Bank and individuals that gold is a useful counter to the swings of any currency. In the last month:

• We saw how the drop in the € against the $ spurred buying interest in gold in Europe.
• We saw the falling Yen spurred Japanese Investor interest in Gold, in Japan.

Clearly there is substantive evidence that Investors globally are becoming increasingly aware of the dangers to all currencies in this increasingly uncertain and volatile world. Individuals as well as others are looking to diversify, not only out of the $ but out of any currency that looks wobbly.

Despite a certain almost nationalistic belief within the States, that the $ is the global currency, and in the face of a relatively steady $ [a 3% two daily move is now thought acceptable], which is performing well despite awful fundamentals, almost to a man, financial experts are hyper-aware of the likelihood of a financial accident in the future [particularly after seeing the report of the record Trade deficit, again]. Part of the problem is the deeply held belief in the $, which is an almost unreasoning one.

So how should and how do Central Bankers look at their gold and foreign exchange reserves and what purpose do they serve? And on what is this view based? Should gold form 15% of reserves, or 5% or 25% or 50%? Below are several views from different nations.

Global Gold and Foreign Exchange Reserves, at present.
To begin with we re-print comments by G.F.M.S. giving perspective on global reserves: -

"The peak in official sector "anti-gold" sentiment has passed, partly as a result of the huge rise in global foreign exchange reserves and the prospect of dollar weakness.

• At the end of September 1999, when the first Central Bank Gold Agreement was put in place, total foreign exchange reserves were $2,011 billion, of which gold constituted 15%.
• At the end of June 2005, this total had ballooned to $4,335 billion (an average annual growth rate of 17.6%), with gold constituting only 9%.

Within this distribution (gold valued at market prices),

• The USA holds 64% of its reserves (defined as foreign exchange, gold and other reserves) in gold.
• The CBGA signatories 42%.
• Japan, meanwhile, only holds 1% in gold.
• Reported figures for China imply 1%, but if other Chinese non-monetary reserves were included then this would probably amount to 2%.
• Other countries hold 3% of their reserves in gold.
• Among the top ten gold holders, excluding CGBA-1 and CBGA-2 signatories, there is little likelihood of sales and if anything there may be the potential for some purchases.
• Venezuela is a potential buyer

Now we look at the view of the I.M.F. a body that stands as a holder of global currency reserves, and as a support to nations across the globe.

The I.M.F. attitude to its gold reserves.

The I.M.F. considers gold as follows: - "It is an undervalued asset held by the IMF, and provides a fundamental strength to its balance sheet. Gold holdings provide the IMF with operational manoeuvrability both as regards the use of its resources and through adding credibility to its precautionary balances. In these respects, the benefits of the I.M.F.'s gold holdings are passed on to the membership at large, to both creditors and debtors. The IMF should continue to hold a relatively large amount of gold among its assets, not only for prudential reasons, but also to meet unforeseen contingencies."

This gives us the sound reasoning behind holding reserves of gold.

But some say it should be held at 15% of reserves!

Gold Reserves 15%?

But then we turn to a view of some observers who have pointed to 'a currently acceptable level of gold at 15% of national reserves' as a basis for indicating future levels of reserves. This is the current view of the European Central Bank, but not shared by the individual nations who form part of the Eurozone.

When we ask the question, 'how do you measure that level in the reserves to understand the percentage in the first place'.

Inevitably a U.S.$ value will be used as a measuring line. But this does not make sense if used as a permanent level. For instance, if we take that 15% based on a $300 valuation of gold, then when gold hits $500 this level has increased to 25%. Does that mean the Central Bank should now sell its gold to bring it back down to 15%? Surely not? Surely it is fulfilling the function for which it was chosen, namely to protect against the falling value of the $.

It appears that this percentage is a level established in the days when currencies were strong. If currencies fail to perform the gold price will increase and provide a growing and sufficient basis for a nation to continue to function financially in times when its currency is dubious. Then if gold reserves are rapidly climbing to a much higher percentage they can act as collateral for international financial loans, such as India sought and gained many years ago.

So we cannot take the view that gold reserves should be at a certain level without stipulating under what circumstances! Certainly too, we cannot take the view that they should be held at a certain level irrespective of circumstances as that would imply they should be sold as currencies weaken and their proportion of reserves rises! Whilst this is common sense it is usually overlooked.

Gold Reserves in case of financial accidents?

The U.S.A. has a gold level of its reserves of 64% and has no intention of selling it, so we are told. Why? What other choices does it have? Which currency should it hold alongside gold? What is the function of these reserves?

With most of their trading partners accepting the $ in payment for its goods and them being paid in the $ for U.S. exports, the need for foreign currency reserves seems to fall away, so it makes sense to hold one's reserves in gold in this instance. Then the function of those reserves can be fully dedicated to the day when the $ has its long awaited accident! The same thinking preceded the Second World War, when the U.S. undertook to acquire the bulk of the globes gold for its reserves. Its use in times of distress was that it was a credible medium of exchange between all [including enemies], with no inherent obligations attached.

But the U.S.A. was able to do that because of the market conditions that persisted at the time. The Gold Standard was in its dying days and the gold price was $20 [or was that the $ was worth 1/20 th of an ounce of gold!]. Having already confiscated the gold of U.S. citizens, the U.S. raised the price of gold to $35 a huge 75% devaluation of the Dollar.

Other nations did not follow! So the Bullion boys in most capitals of the world bought the gold of those nations at the equivalent price of $20 in their own currencies and shipped it to the States to be paid a handsome profit after costs after selling the gold at $35 an ounce. This was just ahead of the War in which the global flow of Capital was disrupted and paper currencies difficult to trade except between 'friends'. This took their gold reserves up to over 26,000 tonnes of gold!

Try to do that today! The mere rumour that a Central Bank has entered the gold market to buy gold is enough to send speculators into the market to send up the gold price. Right now with the changing attitude to gold amongst Central Bankers, we would not be at all surprised to see some publicly committed Central Bank sellers of gold, change their mind and walk away keeping their gold [Germany has already done so, Italy is a signatory to the C.B.G.A. and has stated it has no intention of selling].

China or Japan are fully aware that to gain a significant holding of gold from the open gold market would send the gold price well above $1,000 and once they had finished buying, would see the price drop right back to where it had come from.

Of course they could deal direct, but unfortunately trust is not sufficiently high between them to do this!

Gold producing nations can only achieve a sizeable quantity of gold by buying it from local producers at "market related prices", thereby avoiding the open market and the impact of purchases on the price of gold. We fully expect to see at some point Russian and Chinese gold removed from the open market [including their own local one] and find its way into national coffers!

Reserves to earn a Yield?

In the days of strong currencies where they are trusted, the concept of performance of currencies comes into the picture. We heard a couple of years ago [when gold was still considered a barbarous relic] that reserves should provide a yield, a return on investment. The level of interest rates became a factor purportedly justifying the selling of gold from national coffers. After all if you can get 4.25% from holding the Dollar isn't this better than holding gold. A few were convinced but the majority just raised an eyebrow and said well this justifies selling all currencies, including the € that do not provide an equivalent yield.

Apart from the patently obvious fact that this would promote Tsunami-like flows of capital throughout the world, i f yield were the attraction, then currencies with highest levels of interest rates would be favored, which are inevitably the softer currencies and more likely to lose exchange rate value?

As we watched immediately after the U.S. Fed Funds rate was elevated to 4.25% and the Trade figures were released the $ dropped by 2% demonstrating that interest rate yield on a currency is not an exchange rate moving item and that the constant volatility of currencies negates looking for yield in reserves. Gold and Foreign Exchange Reserves should be a protection against the accidents that can result from volatility and realised uncertainties.

More to the point we live in days when a $ or a € exchange rate can change 1% or 2% in a day, so is it wise to wait for 360 days to get 4.25%? Clearly interest rate yields should not motivate sales of gold!

The Asian view of reserves.

Another [Asian] view of reserves is that a nation should hold its reserves in the currencies of the nations with which it trades in proportion to the levels of trade it does with those countries. It appears that that is how China sees its reserves, in the light of the valuation of the Yuan, in terms of a "basket of currencies" which turned out to be those of its trading partners. This makes practical sense but ignores the possibility of a breakdown in such relations or indeed in the event of a war and the run up to it.

This explains why Asian reserves carry so little gold in their reserves!

Dominant or Satellite currencies?

Reserves of major and minor nations have to fulfil a role of protection in difficult days. In today's world where considerable doubts hang over the currency of the U.S. most nations are concerned at the solidness of their reserves. In a case like Japan or Canada, reserves are mainly the U.S. $. Canada is almost a financial colony of the U.S. and has little use for currencies other than the $ from a Trade point of view. However the concept of abdicating gold reserves [as Canada has effectively done] to become solely dependent on the U.S. $ is not in the interest of the financial stability of Canada in a crisis. Their reserves are failing to give any protection against a poor U.S.$ performance.

The concept of any nation selling its gold in favour of "Dominant Currencies" in this way is unsound financial management and not likely to be emulated by other "Satellite currencies" and their Central Banks except for political or trade reasons.

The example of the Eurozone bears out such thinking on our part. With Germany and Italy and France major holders of gold [even after France's sale of gold] and yet having abdicated their own currencies in favour of the €, we see stiff resistance to the sale of their enormous tonnages of gold. And ask any of them and they will give sound reasons for holding it, [such as, "as an effective counter to swings in the $"]. This is in the face of the Eurozone's own Central Bank holding 15% of its reserves in Gold!

In essence, we have seen gold react as a counter to government issued paper currencies. It is not reasonable or responsible to willingly become totally dependent on paper currencies, particularly if a nation already has gold in its own gold reserves!

The structure of these reserves should be founded on the same reasoning as used by the major powers. After all if a dominant currency should suffer a crisis, a minor nation holding that currency exclusively, will face a far worse crisis than the dominant currency nation and will need alternative assets with which to counter such a crisis!

With gold performing as a currency now, the global reserve currency, the pivot of the global monetary system needs to be looked at to see the future of the global monetary scene. Here is our view of that currency: -

Prospects for the $.

Poor Performance
The $ is the Global Reserve currency. It has for some years had fingers pointed at it as a currency being very poorly managed internationally, with eyes introverted exclusively on the U.S. economy. The nation has a "Live now pay later", "so far so good" attitude to the situation it and the $ finds themselves in at present. With the U.S. trade deficit widening unexpectedly in October to a record $68.9 billion despite a drop in the cost of imported oil, as the deficits with China, Canada, the European Union, Mexico and OPEC all hit records it is reasonable to think that fourth-quarter economic growth will be even weaker than first thought. And if so, how long can this performance continue until disaster strikes?

We should remember that a continuation of oil prices at +$60 [the average was $56.29 a barrel] will keep oil imports at record levels. 2006 will see a repeat of this type of report! As to trade with China we also expect more of the same as we see now. A steadily rising trade deficit with China grew 2.1% to a record $20.5 billion as imports from that country rose 4.8% to $24.4 billion. The inflation beating cheaper imports extended beyond Asia to Canada, Mexico, the European Union and OPEC countries with whom the deficit also widened to record levels.

To date the overall trade deficit reached $598.3 billion. Earlier this year Global Watch - The Gold Forecaster" forecast that the Trade deficit for the year would be $720 billion, a figure ridiculed at the time. But with two more months to go to complete the year, this forecast could be less than the reality?

The U.S. Dollar - Two roles - The Global Reserve Currency and money for U.S. citizens.

As we have highlighted in previous issues, the $ has two roles, a global reserve currency and simply money within the U.S.

It is the global reserve currency role that is keeping it up its exchange rate value. We continue to expect the U.S. Capital account to reflect continuing and rising levels of investment in the U.S. $ [liquid instruments primarily], greater than the Trade deficit.

Its internal role is heading to heavy-duty inflation within the States. It can be bolstered to some extent by rising interest rates [as we saw this week interest rate rises are not lifting the $, but the prospect of these rates rising no more [and the deficit] saw the $ fall]. We do expect the Fed to keep raising rates for as long as the growth in the economy will permit. Many believe the Fed may finally be nearing an end to its campaign of raising interest rates.

There is a deep significance to the path the two roles of the $ is travelling. The global reserve currency role is the steady one relied upon for global trade by all. The internal $ is over-borrowing to finance the continuing boom and internal deficits [now boosted by three Tax cut Bills].

Indeed the external Trade deficit joins the internal budget deficit to undermine the credibility of the foreign value of the Dollar.

When the two eventually meet, the fall will be quick and destructive.

Our view is that the $ will continue along this road until it falls off a cliff. But so long as the $ can pay bills, buy capital goods, buy oil and hold relatively steady on the foreign exchanges it will be bought and held. The moment its external buying power is seen to totter, as a result if internal profligacy, then the breakdown will be swift!

It is this uncertainty ahead of the fall that is helping to raise gold to new heights and will keep on doing so until the Global Monetary system unites in retaining a steady value and reliability to all aspects of its global reserve currency or its replacement!

Conclusions

Do Central Bankers construct their Gold & Foreign Exchange Reserves blithely trusting in a sound monetary future? Perhaps they should follow this course: -

• With such prospects for the U.S.$, the consequential ripple effect on nations using it as a global reserve currency [all of them!], should factor this future into the structure of their reserves.
• Central Banks, in prudently managing their Reserves should plan for situations which they would find themselves in, in the event of a breakdown in the $, or for any envisaged 'rainy day' for that matter.

Clearly, the swing back to gold in our present global monetary scene could well gather pace. But only in a few cases [Gold Producing nations] can gold be loaded into their reserves and two of the main ones have stated they will be increasing their gold reserves [Russia and South Africa] without rattling the gold market excessively [their gold simply won't reach the market].

• Consequently the first action to the return of gold as a reserve asset of real note will be growing inaction.
• There will be a drying up of gold sales from selling banks first, which of itself, will severely reduce supplies to the gold market.
• It is nearly impractical that Central Banks will go into the open market to buy in volume, without triggering a gold price 'spike', in the present supply / demand situation.
• Gold as a Reserve Asset is bound to grow considerably in importance, possibly in line with the rising price.

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Julian D. W. Phillips
Gold-Authentic Money

"Global Watch: The Gold Forecaster" covers the global gold market. It specializes in Central Bank Sales and details, the Indian Bullion market [supported by a leading Indian Bullion professional], the South African markets [+ Gold shares shares] plus the currencies of gold producers [ Euro, U.S. $, Yen, C$, A$, and the South African Rand]. Its aim is to synthesise all the influential gold price factors across the globe, so as to truly understand the global reasons behind the gold price. FIND OUT MORE

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