A central bank may add a tactical overlay of gold to its strategic allocation as protection against certain downside or “tail” risks. Such risks, determined by the prevailing macroeconomic environment, will change over time. Regardless of the scenario, gold provides the most superior hedge or tactical overlay strategy for most macroeconomic events - including general global systemic crises.
European Debt Crisis
In 2010, the European sovereign debt crisis was the biggest risk facing reserve managers. The impact of financial sector bailouts, stimulus packages and lower tax revenues, combined with the slump in economic activity, had a devastating effect on western public finances. Advanced economies’ fiscal deficits reached 9% of GDP in 2009 and public sector debt grew to 90% of GDP, according to the IMF’s April 2010 World Economic Outlook.
A number of advanced economies suffered multiple credit downgrades. The most noteworthy of these was Greece, whose credit rating S&P cut from “A-“ in December 2009 to “BB+” in April 2010. The Greek crisis culminated in a €750bn EU-IMF bailout plan.
The outlook for public finances remains grim. The global recovery remains heavily reliant on monetary and fiscal stimulus for what little growth it has, making a quick reversal in the fiscal situation unlikely. The IMF estimates that advanced economies’ debt/GDP ratios will exceed 100% of GDP in 2014 based on current policies.
That figure equates to some 35 percentage points higher than when the crisis began. As a result, sovereign bond issuance is likely to remain at historically high levels in the coming years and further sovereign downgrades seem likely.
European Sovereign Debt Spreads vs Gold - click to enlarge
Limited Choices among High Quality Assets
The investment guidelines of emerging market and developing country central banks often limit reserves to a few key asset classes. These include deposits, high quality sovereign debt and quasi-sovereign bonds and SDRs. A sovereign debt downgrade to below investment grade reduces the pool of eligible investments for these central banks, while contagion risks lower the attractiveness of similar assets. Most central banks could not, for example, simply diversify into equities.
Gold bears no counterparty or credit risk, and it is a permissible reserve asset in practically every central bank in the world. These attributes make gold especially attractive in this type of environment.
Currency Debasement & Price Stability Risks
Policy makers must also consider the significant issue of paying for the bailouts. Some of the money for rescue packages has simply been “printed”, causing money supply growth to be exceptionally high in many countries. If governments fail to implement effective and timely “exit strategies”, this practice risks fuelling future inflation.
Gold is the only universally-accepted currency whose supply cannot be increased by policy makers. The equivalent of money issuance for gold is new mine production, which has been on a relatively flat trend for the past ten years.
In a recent report, the World Gold Council examined the quantitative relationship between money supply and gold. Data showed that a 1% change in US money supply growth six months prior has an impact of 0.9% on the price of gold, on average. Meanwhile a 1% change in money supply in India and Europe six months prior affects the price of gold by 0.7% and 0.5% respectively.
Gold carries the reputation of being a long-term inflation hedge. Professor Roy Jastram first statistically examined this value in the 1970s. A recent update to his book, The Golden Constant: The English and American Experience 1560-2007 confirmed these findings.
Gold as a Safe Haven
Surprises of the ‘bad news’ category look set to dominate financial markets in the short to medium term. Gold’s role as a safe-haven asset in the event of major economic shocks is well documented. Its performance in the most recent financial crisis (see “Gold and Liquidity” ) provides an excellent example of these wealth protecting properties.
Perhaps less well known is the fact that gold also performs relatively well in the event of milder economic shocks. A recent IMF study4 found that: “gold prices react to specific scheduled announcements in the US and the Euro Area (such as indicators of activity or interest rate decisions) in a manner consistent with its traditional role as a safe-haven and store-of value…”.The study measures the standard deviation from publicly-available consensus estimates for 13 macro-economic indicators. It finds that gold prices tend to be counter-cyclical. The price rises when there is a downside surprise in the data, suggesting a view of gold as a safe-haven during “bad times”. The study concludes that: “Gold’s high sensitivity to real interest rates and its unique role as a safe haven and store of value typically leads to a counter-cyclical reaction to negative surprises that might lead financial investors to become more risk averse…..For longer-term market participants, these results provide confirmation of the pro-cyclical bias of many commodities and gold’s role as a safe haven during periods of economic uncertainty”. This finding would seem to be particularly relevant to reserve managers in today’s highly uncertain macro-economic environment.
Reducing exposure to dollar-denominated assets
Central banks may also impose constraints on their allocation to dollar-denominated assets. The US dollar remains the mainstay of the reserve portfolio of advanced and emerging economies. Of the proportion of foreign currency reserves whose currency composition has been identified, 66% of reserves of advanced economies and 58% of reserves of emerging and developing economies were held in dollars.
There is concern that the US economy’s exceptionally loose monetary and fiscal policy will lead to renewed dollar depreciation. Following the 2007-2009 financial crisis, the dollar’s sustained popularity stemmed mainly from the fact that economic conditions were so bad elsewhere, especially in Europe.
Some policy makers – most notably from China and Russia – even called into question the dollar’s role as a reserve currency and have instead called for greater use of the IMF’s Special Drawing Rights (SDRs).
US Trade Weighted Dollar (Index) and the Gold Price (US$/oz) - click to enlarge
Gold has a long-standing negative relationship with the dollar, making it an effective hedge against any further dollar weakness. There are four good reasons why gold tends to move in the opposite direction to the US dollar.
Firstly, gold is priced in dollars and, everything else being equal, weakness in the currency in which a real asset is denominated tends to lead to an increase in its price, as investors demand compensation for the currency loss.
Secondly, gold’s history as a monetary asset makes it an attractive store of value in periods of high inflation or rising inflation expectations, driven by excessive money supply growth.
Thirdly, the depreciation in the dollar (appreciation in other currencies) reduces gold’s price to buyers outside of the dollar bloc, stimulating demand for it.
Finally, depreciation in the dollar increases the cost of extracting gold overseas and often the price of other commodities used in the extraction process, putting a higher floor underneath the gold price.