Managing gold reserves
Since 2010, central banks have been net buyers of gold, driven in part by uncertainty over the future of the international monetary systems and the need to diversify reserves.
The size and diversity of gold supply and demand mean that it is highly liquid, and remains so throughout periods of uncertainty. Gold’s historic lack of correlation with other reserve assets and negative correlation to the US dollar mean it is commonly used to manage market risk and improve portfolio performance.
Gold can help reserve asset managers reduce portfolio risk and preserve wealth. It is routinely used as a long-term inflation hedge by investors. However, adding gold to a portfolio of assets can also help to reduce risk in other ways.
First, holding ‘allocated gold’ incurs no credit risk. Thus, it is a commonly-used safe haven asset.
Gold has a negative correlation to the most commonly-used reserve currency, the US dollar. This makes it an effective hedge against future dollar weakness. This characteristic of gold is particularly relevant for reserve asset managers who anticipate that the Chinese renminbi will emerge as a serious challenger to the dollar as the world’s reserve currency. Gold is also useful for those who impose constraints on their allocations to dollar-denominated assets.
Furthermore, gold has little or no correlation to other traditional or alternative reserve assets. The diverse drivers of gold supply and demand are independent of, and in many cases opposed to, the forces that determine the value of other assets. This makes gold an effective diversifier that can have a significant positive impact on portfolio performance.
The gold market is comparable in size to other traditional reserve assets. It is also highly liquid and remains so during periods of financial crisis, reflecting the diversity of its demand drivers and the inflows it enjoys during investors’ flight-to-quality.
There are several metrics that are commonly-used to measure liquidity, including bid-ask spreads, turnover ratios and the correlation of price movements with financial stress indicators. A recent study by Europe Economics calculated 19 liquidity metrics for gold. It found that, over certain time periods, gold’s liquidity performance during the last crisis was better than equities, corporate bonds and even sovereigns across many of the measures.
Daily trading volumes are another measure of liquidity. Because the majority of gold is traded over-the-counter, a time series of daily trading volumes is not readily available. However, the London Bullion Market Association (LBMA) estimates that the amount of gold traded between market-making bullion banks in London alone averaged US$240 billion in the first quarter of 2011. On this measure, the gold market is also more liquid than many major bond markets and is more comparable to foreign exchange volumes.
In terms of market size, perhaps the most relevant metric for gold compared to ‘outstanding bond issuance’ is the combined value of gold in private bullion stocks and the official sector – often referred to as financial gold. GFMS, an independent consultancy firm, estimated this to be 69,500 tonnes at the end of 2015. (Using the 2015 average gold price (LBMA Gold Price PM) of US$1,160.1/oz, the value of this tonnage would be US$2.6 trillion.) On this measure, at the end of 2014 gold was larger than each of the major bond markets, except for those in US Treasuries and Japanese government bonds.
From time to time central banks might lend part of their gold to other market participants to earn an additional yield. This is referred to as gold ‘leasing’.
The implied gold lease rate is calculated using the London Interbank Borrowing Offered Rate (LIBOR) and the Gold Forward Offered rates (GOFO).
Lease rate = LIBOR – GOFO
LIBOR is the rate at which banks can borrow dollars from one another on an uncollateralised basis.
GOFO is the rate at which bullion banks are willing to lend gold on a swap against dollars. In other words, it is the interest that would be accrued on selling gold for dollars, and then buying it back a number of months (typically one, two, three, six or 12) later.
The gold lease rate is the spread that can be earned by lending gold or borrowing dollars then reinvesting dollars at the LIBOR rate.
For example, a bullion bank is willing to lend gold for dollars on a swap at 1 per cent. The bullion bank then reinvests these dollars at the prevailing LIBOR rate of 1.5 per cent. The ‘lease rate’ in this case would be 0.5 per cent (50 basis points). Collateralising the transaction with gold effectively reduces the borrowing costs.