Gold is increasingly being used in the financial system as a source of high-quality collateral. Its lack of credit risk and countercyclical behaviour make it ideal for this purpose. The European Market Infrastructure Regulation (EMIR) now permits Central Counterparty Clearing Houses (CCP) throughout Europe to accept gold as collateral. Gold’s use as collateral at commercial banks is also growing. Gold could also serve this function in the public sector, enhancing the credit quality of government bonds and lowering bond yields
Gold-backed sovereign debt
As Eurozone policymakers continue to seek out a comprehensive and lasting solution to the Euro crisis, the key questions remain: how to stem the unsustainable borrowing costs now facing the most challenged Eurozone countries, stimulate the growth required to pay down debt and emerge as self-sustaining robust economies. Numerous potential solutions to this dilemma have been proposed, some of which have focused on how to get the most out of the substantial gold reserves currently held by European Central Banks.
Professor Ansgar Belke, leading Eurozone academic
Natalie Dempster, Director of Government Affairs, World Gold Council, discusses gold-backed bonds with Professor Ansgar Belke.
Dr. Andrew Lilico, Director, Europe Economics
Dr. Andrew Lilico, of Europe Economics, discusses his paper The use of Gold as Collateral for Eurozone Sovereign Debt. The paper assesses the World Gold Council’s proposals on gold as collateral for Eurozone sovereign debt, especially in the case of Italy and Portugal.
Natalie Dempster, Director of Government Affairs
Natalie Dempster, Director of Government Affairs, World Gold Council, discusses the role of gold as a partial solution to the eurozone sovereign debt crisis.
The Eurozone’s gold reserves stand at over 10,000 tonnes, and it is well known that some of the countries worst affected by the crisis, including Portugal and Italy, are responsible for a significant proportion of these assets. These reserves have served those countries well over the years, not least over the last decade, thanks in part to gold’s unique wealth preservation characteristics. Nevertheless, the question is rightly being asked as to the role that these gold reserves can, and should, play to help alleviate the problems now facing the Eurozone and the individual member states within it.
Most agree that outright sales of gold are not the answer. Aside from the obvious problem that the outstanding debt level of the struggling European countries far surpasses the value of their gold reserves, existing EU laws prohibit such a move to finance governments, as do the provisions of the Central Bank Gold Agreement, which limits gold sales in order to protect the collective value of Western Europe’s reserves. To illustrate this point, the gold holdings of the crisis-hit Eurozone countries (Portugal, Spain, Greece, Ireland and Italy) represent only 3.3% of the combined outstanding debt of their central governments. A one-time sale of all of their gold reserves would probably not cover even one year’s worth of their debt service costs. This would be akin to an individual selling everything they owned in order to make one month’s mortgage payment.
If we exclude gold sales therefore, what contribution can gold make to a comprehensive and robust solution? We believe that gold could be leveraged in the short term to allow Europe the much needed time to arrive at longer term corrective measures. In particular, this could be done by partly collateralising new government debt, which we estimate could be issued at substantially lower yields than existing debt.
The European Central Bank (ECB) intends, with its proposed third round of secondary bond market purchases called Outright Monetary Transactions (OMT), to reduce bond yields in the most distressed Eurozone countries. It is trying to fix the “monetary policy transmission mechanism”. In other words, it is trying to bring sovereign debt yields closer to the official Refinancing Rate set by the ECB which currently stands at just 75 basis points.
The OMT and the ECB’s other bond buying programmes have undoubtedly been controversial. While the purchase of government debt in the secondary bond market is not expressly prohibited, for many it has been tantamount to government financing. It has other perceived shortcomings too. Some have argued that by buying back debt, the ECB reduces the incentives for distressed countries to pursue structural reforms. There is also a perceived threat of inflation if the ECB’s purchases are not fully sterilized.
Our analysis shows that using gold reserves to collateralise government debt could achieve the same reduction in yields without the SMP’s associated shortcomings. Firstly, it would not represent a fiscal transfer from one country to another, as a country would use its own gold, to lower its own interest rates, to jump start its own economy. Nor would this disincentivise countries from pursuing much-needed structural reforms. Quite the opposite, the threat of losing one’s gold would surely act as a catalyst. And it would most certainly not be inflationary. Gold is as hard and real an asset as you can get. Finally, it would not affect the ECB’s balance sheet, as the gold that still remains with national central banks would, we estimate, be more than sufficient to collateralise the bonds.
In the Eurozone, gold is held and managed by the European System of Central Banks and decisions on its use are made by the Governing Council regardless of whether or not it has been transferred to the ECB. The Governing Council could, we believe, direct a national central bank to use its gold reserves in such a manner under its secondary objective of supporting the general economic policies of the European Union. Or indeed, justify it in the same manner as it did the SMP.
Europe faces an exceptionally challenging period and unconventional policy responses are called for. A gold-backed bond would seem to offer at least a partial solution to Europe’s woes.