Gold still an important diversifier for central banks – WGC

According to the World Gold Council, central bank allocations to gold remain below optimal levels and should be at around 8%.

The total quantum of official reserves for all central banks has grown from $2 trillion in 2000 to $12 trillion in 2012 and are primarily comprised of US and euro denominated assets and gold.

This picture is changing, however, as pointed out in a new study by the World Gold Council, titled: Central Bank Diversification Strategies: Rebalancing from the dollar and euro.

According to the study, while US dollar and euro denominated assets made up 62% and 16% of the total in 2000, at the end of last year, those same assets comprised 54% and 22% respectively, while the percentage held in gold remained static at 13%.

But, the WGC says, while euro-denominated holdings have risen, “anecdotal evidence suggests that euro allocations may have plateaued as the European sovereign debt crisis has encouraged reserve managers to reduce euro allocations” leading central banks to look elsewhere.

Indeed, the group writes, “IMF data shows that the share of other currencies in reserve composition ahs tripled in absolute terms since 2008.”

These other currencies, namely the Canadian and Australian dollar, Swiss franc, Danish kroner and the Chinese renminbi, says the WGC, have grown in popularity at the expense of traditional reserve assets like the British pound, Japanese yen, the US dollar and the euro.

For reasons behind this shift, the WGC points to the credit quality of countries like Canada, Australia, Denmark and Switzerland and, indeed the promise of greater returns.

“US and European long-term treasury yields have averaged less than 3% over the past five years, which suggests returns are unlikely to surpass the carrying costs associated with official reserves. Meanwhile, rapid growth in China and other emerging markets is driving broad-based investor interest in higher yielding securities.”

On the back of these shifts and premised on the assumption that central banks are seeking to lower their exposure to US dollar and euro-denominated assets, the WGC has done some portfolio analysis.

For the sake of the analysis, the WGC assumed that the trend toward lower allocations to those two countries, to an optimal level of 65%, leaving the remaining 35% to be split between everything else.

If no further constraints are placed on the data, and looking at it from a return, volatility and co-variance perspective, then the allocation to gold should drop to 5%, with Chinese and Australian allocations boosted to 13% and 6% respectively.

However, such allocations face the problem of the relative sizes of those asset markets.As the WGC points out, if such an allocation were implemented across all the central banks, there would need to be a collection allocation to Chinese and Australian reserve assets of US$1.6 trillion and US$720 billion respectively, both of which are greater than the actual market size. And it is here where gold and other more traditional assets like Japanese yen denominated assets shine through.

Taking account of market size, while retaining the 65% in US dollars and euros, the WGC says the optimal allocation for the remaining 35% should be divided as follows, 8% each, to Japanese assets and gold, 6% to the UK, 5% to Canadian assets, 4% to China, 3% to Australia and 1% each to Swiss and Danish assets.

Thus, the WGC believes, “building gold reserves in tandem with new alternatives is an optimal strategy as these markets need time to develop and allocations to gold remain largely below optimal levels.”

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