On Friday afternoon, the European Central Bank announced that its 20-year old Central Bank Gold Agreement was no longer necessary, while confirming that: “Gold remains an important element of monetary reserves” – we couldn’t agree more.
This agreement dates back to 1999 when the gold market looked very different to it does today. The agreement was designed to limit the amount of gold that was collectively sold by (mainly) European central banks. These banks were left with large legacy stocks from the Gold Standard and Bretton Woods days and, the world having moved on to a system to floating exchange rates, no longer saw the need to hold such high levels of gold.
But the sales were destabilising, causing the gold price to fall and gold volatility to rise. The export earnings of gold producing countries were also negatively affected. To address these issues, central banks agreed to give the market forward guidance on their gold sales and to limit the collective amount. The agreement helped to stabilise the gold price.
Two decades on and things are very different. The gold market is deeper and more liquid. It is also structurally different, thanks in part to the launch of gold exchange-traded funds, but also to the growth of India and China, and the liberalisation of the latter’s gold market. But the most important difference is in the behaviour of central banks themselves.
Over the past decade, central banks have purchased more than 4,300 tonnes of gold, bringing their total monetary gold holdings to 34,000 tonnes. Last year, they bought the most monetary gold ever (656 tonnes) under the existing international monetary system. Even Europe was a net purchaser of gold last year, thanks to large purchases by Hungary and Poland. It is likely to be again this year, due to an enormous 100 tonne additional purchase announced by Poland in June.
So, what’s driving it? Central banks have different strategic objectives to institutional investors. Their reserves are there to help during times of balances of payments crisis or other emergencies, amongst other things. As such, they must be invested in assets that are safe and liquid. This is reflected in their investment guidelines, which in the case of emerging and developing country central banks are usually very narrow. They are often limited to gold, SDRs, IMF reserve balances, highly-rated sovereign debt and deposits.
This makes central banks disproportionately exposed to advanced economy debt. But the yield on many of these sovereign bonds is negative in both real and nominal terms. And the risks associated with them are rising. Central bank’s independence is being challenged, giving rise to fears about debt monetisation. We are seeing diminishing marginal returns to extraordinary monetary policy measures. Currency wars are a real threat. The UK and EU are locked in a standoff over the Irish backstop, and the hard line taken by new Prime Minister Boris Johnson has increased the risk of a no deal Brexit.
It is against this environment that gold looks relative more attractive than other reserve assets. It has no political risk, it cannot be de-based by the printing presses or extra-ordinary monetary policy measures and it cannot be talked down in a currency war of words. It is no wonder that our 2019 Central Bank Gold Reserve survey, released last week, signalled just as strong central banks buying is still to come.