President''s new chief of staff wants Goldman Sachs CEO as Treasury secretary


By Eckart Woertz
The Daily Star, Beirut
Thursday, March 30, 2006

The prospect of selling oil for inflated dollars should send Middle
Eastern central banks to the logical hedge commodity: gold

There is no doubt that gold is regaining its luster as an asset
class. After it has been in a bear market for two decades, with
prices plummeting nearly as low as $250 in 2001, its dollar price
has more than doubled within four years and stays now well above

The women of India and the Middle East, who represent the two most
important demand factors in the world gold market, have thus
outperformed the sophisticated hedge funds of Wall Street with a
very basic "gold, buy and hold" strategy. The performance of gold-
mining stocks is even more impressive: The HUI index of gold mining
stocks rose from 35 to more than 300 in the same period.

There are ample reasons for this price hike: The U.S. trade deficit
has spiraled out of control. Compared to its economic base, the
accumulated debt in U.S. dollars has become too high to be
effectively repaid; it will either default or will more likely be
inflated to such an extent that it won't hurt to "pay" it back.

Alan Greenspan's successor as governor of the Federal Reserve Bank,
Ben Bernanke, has made this sufficiently clear when he said that the
Fed would rather start the "electronic printing press" and let rain
down free "helicopter money" on the people than face deflationary

Additionally, the market has become increasingly aware of the huge
supply deficit in the gold market. According to Frank Veneroso
(2001), who challenges the official statistics of the World Gold
Council, mine production only accounts for roughly half of the
annual demand and is declining.

Apart from scrap supplies, the most important filling of the gap
comes from the central banks, which sell and lease gold into the
market. The latter activity is especially tricky and has led to a
huge derivative short position in the gold market: Western central
banks mainly lease gold to commercial banks, which sell it into the
market, the central banks earn a lease rate and the commercial banks
invest the proceedings of the sales in higher-yielding assets like
bonds, for example.

Everybody could be happy, but there is one problem: the gold still
exists as an asset on the books of the central banks and as a
liability on the books of commercial banks or hedge funds, while the
actual physical gold has left the vaults a long time ago and now
hangs around the necks of the women of the world, who are
the "ultimate longs" in the market without even knowing it. It is
inconceivable that this short position can be covered at current
prices and the market seems to reckon that at some point the central
banks won't be able to cover the supply gap because they will run
out of gold or won't be willing to sell more of one of their most
valuable assets.

First signs in that direction are already discernible: An increasing
number of central banks like Russia, China, and Argentina are
actually buyers of gold in order to diversify their currency
reserves and Western central banks appear to be increasingly
reluctant to enact further sales (e.g. Germany) or have sold or
leased out most of their gold (e.g. England and Portugal). Thus,
apart from the inflation fears and the dollar weakness, the supply
gap and the derivative short position is the third main driver of
the gold price rally of recent years.

These underpinning fundamentals are so strong that one can safely
assume that we are still at the beginning of a secular price rise
rather than at its end. In fact, the accompanying boom in commodity
and oil prices and unstable political developments remind one of the
gold price rally of the 1970s, when gold prices rose more than
twenty-fold from $35 to $850.

Individuals in the Gulf countries seem to be well-prepared for these
developments, as they are the second-most important buyers of gold
in the world after India, but the central banks of the region have
not shown the same amount of foresight yet. Their gold reserves are
very low, both on an absolute and a relative level. Four countries --
the U.A.E., Oman, Qatar, and Bahrain -- have sold out nearly all of
their gold while Kuwait has leased out its complete reserves with
uneasy prospects of return, should third parties default. This is
all the more astonishing as gold constitutes a superb hedge against
inflation and dollar weakness and could thus mitigate the danger of
being short-changed by selling precious oil for rapidly devaluing
paper dollar receipts.

A minimum rate of gold reserves like the European Central Bank (ECB)
stipulates for its members (15 percent) and an increase of gold
reserves like Russia recently announced (from five to 10 percent)
certainly would be an advisable policy for the Gulf countries. But
so far they seem to have unshakable trust in the U.S. dollar.

After initial attempts at currency diversification, OPEC countries
increased their dollar holdings in 2005 again from 61 percent to 69
percent and the skyrocketing amount of U.S. treasury buying out of
London has been attributed to Arab investors. This is in striking
contrast to Japan and China, which have partially backed out of the
dollar supporting scheme as they have kept their treasury holdings
stable and refrained from buying as much as they did earlier.

The interest in gold by private Gulf investors is mirrored in the
impressive rise of Dubai as a major gold-trading city in the world.
In 2005, more than 10 percent of the worldwide demand was imported,
and with the establishment of the Dubai Gold Exchange (DGX) the city
is poised to become a major international gold trading center. Dubai
constitutes a convenient time window between Asia and Europe and the
DGX will be the only exchange worldwide to offer trading on
Saturdays and Sundays. Therefore, it can be expected that in the age
of the Internet an increasing amount of international investors will
be attracted to Dubai as well.

Another advantage of Dubai is that it won't limit itself to the
trading of "paper gold" contracts (futures and options) like Tokyo
and New York but will be supported by its vivid trading in physical
gold. This will become increasingly important as trust in derivative
paper gold might wane in light of the problematic derivative short

One might remember in that respect that the COMEX in New York
renounced physical delivery into silver contracts in 1980 after the
metal rose to $50 in the wake of the famous Hunt brothers'

But to retain its status as a center of physical gold trading, Dubai
cannot count on Western central banks to fill the supply gap
forever. There will be a time where the only available new supply
will come from mining companies and like the owner of a petrol
station is naturally interested from where the oil he sells comes
from, Dubai and the region should develop an interest in upstream
investments in the gold sector to safeguard future gold supplies to
a thriving gold trading hub.


Dr. Eckart Woertz is the economics program manager at the Gulf
Research Center in Dubai.


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