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Gold: Historic Spike Ahead?

It is common knowledge that the British government sold more than
half of the nation's gold reserves at the bottom of the market in
mid-1999. It's less well-known why.

By Brian Durrant
Wednesday, March 22, 2006

The Treasury sold 395 tonnes of gold from July 1999 to March 2002 at
an average price of $275 per ounce. The sale raised $3.5 billion.

Why? The Treasury claimed that gold was expensive to store and keep
secure. It was also inconvenient to trade if transactions involved a
change of storage location. But in other words gold was too
traditional and old-fashioned, an anachronism for New Labour.

Now gold is twice the price at which the government sold it. The
cost to the taxpayer of this policy to "modernise our reserves"
equals some 2 billion. You may recall that the Conservative Party
irretrievably lost its reputation for economic competence in
September 1992 when it spent 800 million trying to keep the pound
in the European Exchange Rate Mechanism. But alas, the media, the
electorat,e and the opposition now take a kinder view of wasting
taxpayers' money.

According to Tony Blair's comment to the House of Commons, the gold
sale "was carried through perfectly sensibly and we actually got the
best deal for the country." We know the second part of his statement
was rubbish. But were the gold sales carried out sensibly?

On 7 May 1999 the government announced in advance that it would sell
415 tonnes of gold. This public announcement seemed to ensure that
the UK would achieve the lowest possible price rather than the
highest. The first auction of 25 tonnes in July was $26 per ounce
lower than the price at the time of the announcement!

In selling our gold the government was a great believer in overt
sales. In other words, showing its hand to the market. The Treasury
reckoned that predictability and transparency would increase revenue
by increasing participation in the sale. The government bent over
backwards to be "fair" to buyers of gold, wanting to maximise sales
rather than striving to get the best price. The issue of "fairness"
for the taxpayer took a back seat.

So is that the end of the story, just another example of government
incompetence? Or was there a hidden agenda?

There is an extremely controversial piece of research that, if true,
suggests that the British government is more knave than fool.

A recent report from metals and mining analysts at Cheuvreux -- part
of France's largest bank, Credit Agricole -- says that the sale was
in fact designed to keep the gold price down. The British
government's actions of mid-1999 are cited as clear evidence of a
global conspiracy to rig the gold market.

The conspiracy theory begins in the 1980s. Central banks began to
lend or deposit part of their gold holdings with leading bullion
banks like JP Morgan Chase, Goldman Sachs, and Citibank. In return
the central banks earned a fee known as the gold lease rate.

At the time this seemed a sensible use of gold. Otherwise it earned
no income for the central banks. But the bullion banks who borrowed
it then sold this gold into the physical market. There it was most
likely turned into jewellery and was lost from the global bullion
market forever.

The bullion bank used the proceeds of these gold sales to buy a
higher-yielding asset like bonds. This was a classic "carry trade."
Borrow at a low gold lease rate, lend at a higher government bond
rate. Money for old rope, in fact ... provided that the gold you
borrowed in the first place didn't rise in price.

Not surprisingly this transaction was very popular in the 1990s. The
gold price was flat on its back. In fact, Cheuvreux reckons tha
central banks loaned out between 10,000 and 15,000 tonnes more from
their gold reserves than they've declared!

And you can see the problem. Sooner or later the bullion bank will
be obliged to deliver the borrowed gold back to the central bank. It
has to buy it in the physical market, incurring substantial losses
at today's 25-year highs, and also squeezing the gold price higher
still -- thus making the situation worse for other bullion banks
that are also short of gold. The risk of a serious global crunch
becomes very real.

Was the Bank of England aware of the risks posed by a rising gold
price? Cheuvreux's research cites a lawsuit filed in December 2001
by Reginald Howe, a member of the Gold Anti-Trust Action Committee
(GATA), a group hitherto seen as on the lunatic fringe of the "gold
bug" community but now supported in its claims by the French bank's

Howe charged the Bank of International Settlements, Alan Greenspan,
the leading investment banks, and many others with rigging the gold
market -- which is illegal under U.S. law. In his suit, he alleged
that in 1999 the governor of the Bank of England, Sir Edward George,
made the following comment to the chief executive of Lonmin, the
gold mining company:

"We looked into the abyss if the gold price rose further. A further
rise would have taken down one or several trading houses, which
might have taken down all the rest in their wake. Therefore, at any
price and at any cost, the central banks had to quell the gold
price, manage it. It was difficult to get the gold price under
control but we have now succeeded."

What might Steady Eddie have been referring to?

The UK government's announcement that it would sell half the
nation's gold reserves came just eight months after the notorious
bailout of Long-Term Capital Management (LTCM) in September 1998.
That collapse had indeed threatened the global banking system.
Cheuvreux now claims tha there were strong rumours that LTCM, a
hedge fund, was short of 300 tonnes of gold when the company
crashed. This short position is thought to have been assumed by the
banks involved in the bailout operation.

In other words, the new revelations from Cheuvreux add weight to the
circumstantial evidence surrounding a global conspiracy to suppress
the gold price. But history tells us that governments cannot rig
prices forever. At some point the free market will out.
The US could not hold the gold price down at $35 per ounce in 1971.
The Tin Council failed to hold up the price of tin in 1985. And the
British government, thankfully, couldn't stop the pound falling out
of the ERM in September 1992.

The scale of official gold reserves that have been lent on to
bullion banks mean there is a huge "short" position that needs to be
covered by gold purchases in the physical market. Indeed, this short
covering seems to be under way.

From mid-2004 to mid-2005, the central banks' official short
position in the market fell by 2,430 tonnes. During the same period
some 232 tonnes of new mined gold was delivered back to the central
banks. So there was short covering of gold of some 2,198 tonnes.
This figure dwarfs official central bank sales, which would have
been 500 tonnes at most. No wonder the gold price shot up during
this period.

And according to Cheuvreux there is much more short covering to
come. Its conservative estimate of the central banks' total short
position is 10,000 tonnes. Only a fraction of this will be met by
new production. The rest will be made up of either physical
purchases of gold or the bullion banks' cash settling. In either
event, the central banks must give up any hope of getting their gold

Or so the story goes. What do other members of the gold market think
of Cheuvreux's claim?

There has been no official statement rejecting the thesis. But the
word in the City is that no one in the gold market believes it. It's
a crackpot piece of research playing into the hands of the
conspiracy theorists.

Indeed, a spokesman at the World Gold Council believes that the
research has zero credibility. But what's for sure is that the
Cheuvreux story is not remotely priced into the value of gold today.

In other words, Cheuvreux's thesis may indeed be proved as nonsense.
But the gold price will not flinch if this is the case. And you can
conclude, as we did in 1999, that the British government was simply
incompetent in disposing of half the nation's gold.

On the other hand, however, Cheuvreux's claims -- if correct -- mean
that Britain sold gold to shore up the global financial system. The
verdict of government incompetence would be changed to one of

There are plenty of other reasons to hold gold -- as a hedge against
inflation, an alternative asset to paper currencies, and as a safe
haven in times of heightened geopolitical tension. But in holding
gold you are also paying nothing for the option that Cheuvreux's
controversial thesis might be true. If you haven't bought gold
already, we advise you take a position in the physical market,
buying gold coins that trade for a small premium to the spot price.


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