A decade into gold's ascent, Financial Times concedes its legitimacy

Section:

Gold: Value Locked In

By Javier Blas and Jack Farchy
Financial Times, London
Sunday, September 26, 2010

http://www.ft.com/cms/s/0/4b148650-c9a1-11df-b3d6-00144feab49a.html

It was a gold rush -- but in reverse. For nearly 20 years the world's central banks, from Canada to Switzerland and Belgium to Australia, were hustling to sell their once-prized gold bars. Around the turn of the millennium the selling became so intense that traders joked about "the new miners," comparing central banks with the Californian prospectors whose 19th-century gold rush flooded the market.

Bullion, which for centuries enjoyed a near-mythical importance as a symbol of monetary stability, had become deeply unfashionable, considered a non-yielding relic. Central bankers wanted sovereign debt with its steady returns rather than coffers full of 400-ounce bars, which incur storage and insurance costs and carry no promise of a reliable yield.

... Dispatch continues below ...



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Fast-forward 10 years, add the financial crisis and growing concerns about rising sovereign debt levels, and that anti-gold philosophy has been turned on its head. "For two decades the only question for central banks was how much and how soon should they sell their gold," says George Milling-Stanley of the World Gold Council, a producers' lobby group. "Increasingly the question is how much and how soon should they buy."

The policy about-face from central banks -- not only the most cautious of market participants but also those in command of the most information -- underscores how the crisis has transformed the global market landscape.

Amid a broad loss of confidence in the financial system, from Wall Street titans to governments, gold has gained traction for a simple reason that has afforded it a central place as a store of value for more than 2,000 years: It is nobody's liability. At the same time, the metal's ascent reflects widespread fears that the central banks' own unprecedented monetary policy moves will lead to the debasement of paper currencies and runaway inflation, making hard assets the only reliable store of value.

For the gold market, the reversal of the trend of central bank selling is one of the most important developments in recent history. As a vote of confidence in gold, it has given investors, from billionaires with Swiss vaults to pensioners with a few coins, the confidence to buy bullion. More importantly it has removed a large source of supply from the market.

Evy Hambro, manager of BlackRock's Gold & General fund, says the change in central banks' behaviour is "one major factor supporting" prices. John Levin, head of precious metals sales at HSBC, simply calls the shift a "game changer." It has propelled gold prices to an all-time high of $1,300 a troy ounce, touched last Friday. Adjusted for inflation, however, the yellow metal is a long way from its 1980 peak of more than $2,300.

The change -- which today will be a main topic of discussion at the London Bullion Market Association annual conference in Berlin, the industry's main gathering -- is partly the result of a natural end to European sales after all the years of large disposals. But it also reflects the shifting global power map: As Asian economies' might grows, their central banks and sovereign wealth funds are stocking up on bullion.

The clearest sign of the new trend is Beijing's announcement last year that it had almost doubled its gold reserves: With 1,054 tonnes, it has become the world's fifth-biggest holder of the metal. More recently, India, Saudi Arabia, Russia, and the Philippines have announced big additions to their official gold reserves, while others, from Sri Lanka to Bangladesh, have made smaller purchases. Traders and bankers say further countries and their sovereign wealth funds are also quietly buying gold.

GFMS, a consultancy, estimates that central banks as a group will be buyers of gold this year for the first time since 1988. On a net basis, the purchases are forecast to be small, at around 15 tonnes. Large official purchases of gold -- in the hundreds of tonnes -- have not been seen since 1965, prior to the collapse of the Bretton Woods system of fixed exchange rates linked to the gold price.

But since the early 1990s a steady flow of uncoordinated sales from central banks contributed to a relentless drop in gold prices. The final blow for the market -- and the credibility of bullion as an asset -- came when the UK Treasury in May 1999 publicly announced that it would be selling half of Britain's gold reserves. The shock sent prices to a 23-year low, at just above $250 an ounce.

The move by London was profoundly symbolic. The Bank of England had for centuries supported the development of the bullion market; the first gold standard was set in 1717. Even though it abandoned that mechanism decades ago, London remained then, as now, the centre of the industry. Investors worried that if Britain was selling, others would soon join in.

They were right. Countries such as Spain halved their gold holdings in a new rush to sell; France started a programme of large disposals. From 1990 until last year central banks around the world sold about 7,500 tonnes of gold. Over the last decade they have dumped 442 tonnes each year on average, more than the annual output of China, the world's biggest producer, and equal to about 10 per cent of annual demand, according to GFMS.

The effect on the market was such that, in order to halt the precipitous slide, Europe's central banks from 1999 have capped their annual gold sales. The agreement was renewed last year, but selling from European central banks has all but dried up. In the first year of the new agreement, which ended on Sunday, the 19 signatories sold less than 10 tonnes.

Will the new buying trend continue, or even accelerate? The gold industry is split. Some argue that gold accumulation by Asian central banks will escalate, but others see this year's purchases as an aberration, with a return to the net selling that characterised the last 20 years.

Among those who see an escalation, in demand, one statistic in particular has the "gold bugs" rubbing their hands. The proportion of bullion as a percentage of official reserves in the BRIC countries -- Brazil, Russia, India, and China -- averages just 5 per cent, compared with more than 50 per cent in the US and most European countries. That means developing nations are thought likely to buy gold to diversify the risk in their reserves. Recent buying by India and Russia, which is purchasing its entire domestic mine output, and suspected purchases by China in its domestic market indicate that the theory could be proved right.

But there are reasons for caution. The gold market cannot accommodate large buying by central banks without sending prices through the roof: The entire global gold supply is worth less than $200 billion a year, compared with global foreign exchange reserves of $8,500 billion. Central bankers joke that gold is similar to what the Norwegian krone is on the foreign exchange market: too small for diversification.

At best developing countries may therefore increase the proportion of bullion in their official reserves over time by a few percentage points.

Take China. After a decade of strong accumulation of assets, Beijing holds 1.6 per cent of its $2,500 billion reserves in gold, with the rest mostly in US Treasuries, sovereign debt and other foreign exchange instruments. If the country was to increase the proportion of gold in its reserves to the world average of 10.7 per cent, it would need to buy some 7,000 tonnes -- equal to three times last year’s global mine output.

Yi Gang, the head of the State Administration of Foreign Exchange, the entity that manages China's reserves, has all but ruled out such a large-scale market purchase.

Philip Klapwijk of GFMS says that on-market purchases by China would immediately push the gold price too high. "As such, it is more likely that some discreet buying could take place quietly in the domestic market via purchasing either local mine production or scrap available in the market," he says.

But he cautions against dismissing potential buying because of its difficulty, noting that by buying, for instance, 100-150 tonnes from the domestic market each year, central banks in certain emerging nations could in due course achieve a meaningful adjustment.

W hile there are good reasons why developing countries' central banks may continue buying gold in the future, there is a strong rationale too for anticipating further selling by developed countries, particularly in continental Europe.

Even after two decades of heavy selling, the proportion of gold in some countries' reserves is way too high, according to some consultants and bankers. Portugal is one of the most extreme cases -- Lisbon holds more than 80 per cent of its reserves in gold. On average, the member states of the eurozone hold 58 per cent of their official reserves in gold, according to official statistics.

The proportion is well above the de-facto target set by the European Central Bank of about 15 per cent of its reserves in bullion. As soon as the financial crisis ends, bankers and advisers believe European central banks that are overweight in gold will start selling again, profiting from current record prices. "I would be willing to bet that in the next five years central banks on a net basis will be gold sellers again," says Terrence Keeley of Sovereign Trends, an advisory firm.

All the same, the universal rush to dump bullion of the late 1990s is unlikely to be repeated any time soon. With nerves still jangling in Europe, the region's central bankers are leery of appearing to be forced sellers. In the near term, bankers and analysts see little prospect of any gold sales from the official sector once the International Monetary Fund completes a 400-tonne disposal at some point next year. In general, most believe that the next decade would not see much buying or selling.

Mr Keeley says that central bankers have been stung by criticism for poor market timing on gold. The UK, for example, sold its gold at the bottom of the market in 1999 and other European central banks have disposed of it at prices below $500 an ounce.

"Central bankers abhor controversial headlines. When it comes to gold especially, they'd rather do nothing than stand accused of doing something wrong," he says.

This is one case, though, where the effect of doing nothing is profound.

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