Gold still important to Central Banks - ECB's Mercier

The European Central Bank's Principal Advisor in Market Operations Paul Mercier told the London Bullion Market Association that sales represent reserve optimisation, not an expression of disaffection

EDINBURGH - 

At the annual meeting of the 2009 London Bullion Market Association (LBMA) in early November, M. Paul Mercier, the European Central Bank's Principal Advisor in Market Operations (and described by Michael Cross, Head of Foreign Exchange and Reserve Management at of the Bank of England as "one of the giants "in his sphere) emphasised the importance of gold to the official sector.  Citing four important reasons behind the rationale for holding gold, M. Mercier concluded with a wonderful example of a central banker's verbal under-statement, saying that even if some central banks continue to sell "we cannot be certain that [world official sector] gold holdings will continue to decline in coming years". 

That sounds like a pretty sound assertion of the likelihood of more central bank buying from around the world.  The signatories to the Central Bank Gold Agreement have, as might be suspected, reduced the annual sales cap for CBGA3 (to 400tpa from 500tpa in CBGA2) because of the lack of use of the previous scope.  Co-ordination of the sales under the latest CBGA will be set up as if the IMF, which is proposing to sell up to 403.3 tonnes (and has just announced the sale of 200 tonnes to India), were a signatory to the Agreement.  This was already in the public domain, but it was refreshing to hear the intention underlined once more. 

M. Mercier's description of the activities under the two previous Agreements was also a reminder of the degree of coordination and co-operation among the CBGA signatories.  The first CBGA, it will be recalled, was set up to try and reduce the unsettling impact on the market of large-scale gold sales - and this included the decision of HM Treasury in the UK to sell up to 410 tonnes and which was announced to the market in advance...

It is often forgotten that this was a UK Government decision, coming from the Treasury and not a decision of the Bank of England,.  The Bank was the body that had to set up the sales in a manner that would minimise disruption to the market.  One wonders just how much angst this might have caused in the Bank given that the Government had seen fit to unship the market by making the decisions public.

As well as the UK's proposals, the Swiss government wanted to reduce its gold holdings in an effort to rebalance its portfolio while the Austrian and Portuguese governments also had plans for sales.  The disposals were expedited in an orderly fashion; the Swiss waited for the UK to finish and the Portuguese government then waited for the end of the Swiss sales.

The quotas (400 tpa, total 2,000t) in the first CBGA were filled but the second CBGA at 500tpa or 2,500 total, was nowhere near up to capacity.  Total sales only reached 1,875 tonnes.  The third CGA quota is therefore down to 400tpa.

M. Mercier noted that at the end of 1998, world central bank holdings of gold amounted to 33,500 tonnes and that by the end of 2008 this was down to 29,700 tonnes so that the rate of disposal over the decade was the fastest in history - and still the price doubled.

The four primary reasons for a central bank to hold gold were listed as follows:

• Economic security  the physical and chemical characteristics of gold with its high density and resistance to oxidation, for example (unlike silver, the oxidation of which is the cause of tarnishing) combine with the fact that it is the only asset that is no-one else's liability to make it a vital element of foreign exchange reserves.  Holding another party's securities always carries the possibility that the behaviour of the counter-party can affect the value of those securities.
• Unexpected needs         there is always a possibility, albeit very low, of highly damaging developments such as war or high inflation that can have a severe impact on sovereign debt, or result in a country's isolation.  As the ultimate global means of payment gold is an important insurance policy.  It  can also be used as international collateral (for example the loan to the Banca d'Italia from the Bundesbank in the early 1970s).
• Confidence        although gold no longer backs currencies in circulation, M. Mercier argued that it helps to underpin international confidence in any one currency, especially since, without gold's formal backing, currency values are based on faith in one another.  He reminded us of the IMF's recent reiteration of the IMF's  statement about hoe gold gives a "fundamental strength" to its balance sheet. 
• Risk diversification         This, he asserts, is probably even more highly valued by central banks than it is by other investors.  There is a considerable body of study that quantifies the ways in which gold brings robustness to a portfolio, most notably, for a central banker, the reduction in volatility.

Risk diversification is an increasing issue for non Euro System central banks and while M. Mercier noted that it is almost impossible to second guess other central bankers he also points out that in recent years a number of public sector bodies (such as sovereign wealth funds) have changed their investment approaches in recent years and gold could well be one of the beneficiaries of these shifts in approach.  While the CBGA signatories hold roughly 50% of their reserves in gold, some of the word's largest foreign exchange holders hold 2% or less.  He did not try to put words into the mouths of his Asian counterparts, but suggested that they are unlikely to be sellers and if anything there might be stabilisation or an increase in gold holdings in the region.

In conclusion; although the gold price itself can be volatile, it makes sense for public sector bodies to hold gold as a diversification against risk; and as observed at the outset, "we cannot be certain that gold holdings will continue to decline in coming years".

These and other factors mean that, while some members of the Euro System are selling gold this is not an expression of dissatisfaction.  It is a process of optimistising the balance of the reserve portfolio and gold remains a vital part of the system.

Disclaimer

MINEWEB is an interactive publication, with rolling deadlines through each day, commencing in the Sydney morning,  and concluding, 24 hours later,  in the Vancouver evening.  If you believe your side of an issue deserves inclusion, but has failed to meet one of our deadlines, you are invited to notify the Editor in Chief in Johannesburg, and we will include you in our editing and expanding on our stories. Email him at alechogg@gmail.com

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