Check out Revolution 2020 by Chetan Bhagat @ Rs 20 - Refer & Win

Check out Revolution 2020 by Chetan Bhagat @ Rs 20 - Refer & Win

Check out Revolution 2020 by Chetan Bhagat @ Rs 20 - Refer & Win

Check out Revolution 2020 by Chetan Bhagat @ Rs 20 - Refer & Win

Recent Global Crisis and the Demand for Gold

Recent Global Crisis and the Demand for Gold by Central Banks: An Analytical Perspective(Excerpts)

A Karunagaran (RBI) 

Introduction

Ever since global financial crisis erupted, there seems to be a perceptible escalation in gold price. Although a number of reasons have been conjectured, the augmentations of the official reserves of gold across many countries have been widely perceived as one of the important cause for spiralling gold price.  This is corroborated by the recent gold investment digest (WGC, 2010) which reported that after two decades, a steady source of supply to the gold market, in 2010, central banks had become ‘net buyers of gold’. India also officially purchased 200 tonnes of gold from IMF in October 2009, which placed its position ahead of Russia to ninth place (Bloomberg, 2009). However, with continuous purchase of gold by many central banks during 2010, Russia progressed to eighth position, while India was pushed to eleventh position (WGC, 2010). Besides, it was reported that India’s purchase of gold was among the factors that impacted gold price in the world market and also boosted the price expectations (commodityonline, 2009). However, Subramanian (2010), stated India’s acquisition of gold, from the IMF is seen with some national pride, as a reversal of the early 1990s decision to mortgage gold. Similarly, India’s purchase of gold was also viewed with the rationale that the uncertainty of the major reserve currencies, (viz., the dollar and euro) spurred central banks, including India and China, to buy gold. The Reserve Bank had stated that gold was bought with the intent to diversify its foreign exchange reserve, which is not uncommon among the central banks. In this background of widely divergent observations, attempt is made to examine (i) whether Reserve Bank’s purchase of gold is an aberration or a strategy to diversify its foreign reserves, (ii) the global trend of gold in official reserves among the central banks, especially during and post global crisis (iii) whether RBI’s purchase of gold influenced the escalating gold price trend and (iv) to trace the economic rationale for central banks to prefer buying gold, especially during crisis. 

Recent Global Financial Crisis and the Demand for Gold by the Central Banks: Some Evidence

The period between mid-2007 and 2009 have been the most tumultuous in financial markets’ recent history as the world economy plunged into ‘Great Recession’ a la Volcker (2009) since the ‘Great Depression’. It resulted in banks collapse, equity markets tumbled across the globe, trade shrunk, capital flows dried up, growth slumped and credit spreads escalated sending investors fleeing for the cover of traditional safe haven assets such as government bonds and gold (Green, 2009). Most notably, the unique feature of the ‘Great Recession’ was that, it virtually put even the long trusted financial institutions, to ‘acid test’ on their competence of ‘liquid portfolio’ management. Moreover, brought to the fore the extraordinary vulnerability of the global financial system to disruptions in wholesale funding markets (IMF, 2011B). Even century old financial institutions were reduced to rubble. It is distressing to note that, even after the lapse of three years, the global recovery remains elusive and heavily reliant on monetary and fiscal stimulus for whatever little growth it has, making a quick reversal in the fiscal situation unlikely (IMF, 2010). Downside risks were increasing and continued to do so in early Financial Year 2011 (IMF, 2011A). In fact, symptoms of excessive risk taking are evident in a few advanced and a number of emerging market economies (IMF, 2011B). The IMF estimated that advanced economies’ debt/GDP ratios will exceed 100 per cent of GDP in 2014, some 35 percentage points higher than when the crisis began. As a result, sovereign bond issuance is likely to remain at historically high levels in the coming years and further sovereign downgrades seem likely (WEO, 2010). Accordingly, adding to the woes, some of the prominent European countries’ (i.e., GIIPS)⁵ sovereign bonds debacle shook the confidence of investors and institutions in the sovereign bond market. Over and above, the latest and biggest in the series of events that contributed to the uncertainty in global markets was the recent downgrading of the U.S credit rating from ‘AAA to AA+’.  While on the other, the gold market remained liquid throughout the financial crisis and, even at the height of liquidity strains in all other markets (Green, 2009). This reflects the depth and breadth of the gold market, as well as the flight-to-quality tendencies exhibited by investors. Because, gold holds its values even at the adverse market conditions (Baur et al., 2010). A study estimates that the daily turnover volumes in the gold market to be larger than even the UK Gilt and German Bund markets. Despite recession following crisis, gold price soared by 25 per cent in 2009 to US$ 1,087.5 /oz registering the ninth consecutive annual increase. It further continued to increase to reach US$ 1,410/oz by end of December 2010⁶ (further up by more than 24 per cent). Baur et al. (2010) stated since the beginning of the financial crisis in July 2007 to March 2009, the nominal gold price has risen by 42 per cent. Thus gold has proved to be the sole reliable instrument, which bears no counterparty or credit risk, and is a permissible reserve asset, practically, in every central bank in the world. In view of this, many central banks either stopped selling or turned out to be net buyers of gold (Table 4) during the global crisis. Incidentally, it may be underscored that countries opting to buy gold, especially during economic crisis and uncertainty are not new as such trends were observed even during the earlier occasions of crisis. The credit and economic crisis triggered fresh demand for the precious metal, similar to what were experienced during other major global crises, for instance, even the U.S. opted for  steady purchases of gold in the 1930s and 1940s (Green, 2009).

WGC (2010) also reported that the central banks became net buyers of gold for the first time in 21 years.⁷ In the first half of  2011, central banks were net buyers of over 155 tonnes of gold, almost double the 87 tonnes of net purchases in 2010 (WGC, 2011)  –  signalling the end of an era in which the official sector had been a source of significant supply to the gold market.

The Central Bank of Philippines is well known for active buying of gold even from the open market. Therefore, its gold reserve is subject to fluctuation as it buys up domestic production and later sells in the market. The Philippines was also a net purchaser in both 2008 and 2009, in contrast to being a net seller in the years 2003 to 2007. The Philippines central bank has stated explicitly that it holds gold for its diversification, security and inflation hedge benefits. Venezuela, also periodically buys gold from the domestic production but for many years it had used gold in such a way that it did not entail increasing its formal gold reserves. However, it also bought from domestic production adding to its gold reserves during and after the global financial crisis (2009 and 2010).

Similarly, Qatar reported to have added 12 tonnes to its reserves during 2007. The Governor of the Saudi Arabian Monetary Agency (SAMA) has, confirmed that the increase of 180 tonnes in the country’s gold reserves announced earlier did not represent a recent purchase of gold, but rather a reclassification of gold it already owned into the category of official reserves. Germany and France were among the prominent EU countries for big sale of gold but ostensibly slowed down their sale during and post crisis.

Some of the Central Commonwealth Independent States (CIS) countries such as Russia, Ukraine, Belarus and Kazakhstan are also prominent in purchasing gold in the recent years. The Central Bank of the Russian Federation bought almost at regular intervals some quantity of gold thereby bringing the total of Russia’s gold reserves to 664 tonnes (businessworld.com). In 2011, Russia has planned to buy 100 tons  as reported by Bloomberg.com (2011).

China being the world’s top producer of gold overtaking South Africa, revealed  that it had stacked up its own government holdings of gold to 1,054 tonnes from 600 tonnes when it last reported its holdings in 2003 thus increasing its gold reserves by as much as 76 per cent since 2003  as reported by the official Xinhua News in April 2009. Incidentally, China do not permit export of gold ingots, only jewellery are permitted, leaving plentiful supplies for the domestic market (financialpost.com). Ever since the global crisis which impacted the US dollar strongly, China is reported to be converting its sizable forex reserves into gold (commodityonline.com). China has further aggressive programme to buy gold as an alternative asset (Subramanian, 2010).

Mexico bought 93.3 metric tons since January 2011, increasing its holdings from just around 6.9 metric tons to 100 metric tons in recent months. Mexico’s purchase formed part of the central bank’s ordinary investment activities, and the gold represents about 4 per cent of the nation’s international reserves as reported by the Banco de Mexico. It further clarified that these purchases are part of the “regular policy of the Bank in regards to investment and diversification”.

The Bank of Thailand also purchased 15.6 tonnes of gold in July 2010. With the country’s foreign currency reserves growing rapidly in recent years, this purchase helped to restore the proportion of gold in Thailand’s total reserve portfolio. Along with India, Bangladesh and Sri Lanka also bought gold from IMF at around the same time. South Korea's central bank became the latest official sector buyer, announcing the purchase of 25 tonnes, its first foray into the gold market in more than a decade (Reuters, 2011).

It is amply clear from the above survey, the series of events in recent years, notably the unsettled global financial crisis, followed by the GIIPS debt crisis and the recent downgrading of sovereign credit rating of the U.S. have tipped the balance away from net selling of gold by the official sectors towards net buying. Seen from that perspective, two aspects become palpable. Firstly, the increasing uncertainty due to global financial crisis and aftermath pushed central banks, both advanced and emerging economies to stock up gold. Secondly, India’s recent purchase of gold is no exception and is in line with global trend. Thus the recent global macroeconomic and financial crisis has only reinforced the importance of gold as part of official reserves in the balance sheets of central banks around the world. The IMF’s latest Annual Report (2010) also revealed that the market value of gold reserves increased by 25.2 per cent, largely due to substantially higher gold prices in 2009. There is also a perception that ‘…the strategies of reserve managers have changed in the last couple of years since the global financial crisis...’(Natalie, 2011).  Further, she stated  that there is much more ‘emphasis now on risk-management strategies, as opposed to yield enhancement…’

Although central banks do not always publish the reasons for their reserves management decisions and even when reasons are publicly announced they are unlikely to fully reflect the long deliberations that go into develop policy (WGC). Pihalman and Han (2010) however, stated that central banks reveal ‘...slowly, but surely more and more information about their reserves management activities typically in their annual reports...’ Nonetheless, it is not always extremely hard to surmise the reasons for such accumulation.

Thus, the global financial crisis and the series of events following the crisis have clearly resulted in increased uncertainty and the corresponding increase in the demand for gold. More central banks are buying the precious metal to hedge against the euro and dollar debt crises (Deutsche Welle, 2011). Further, with down grading of the US credit rating and the consequent global uncertainty, there are views that buying trend of gold will continue upwards as long the debt problems in Europe and the US remain unsolved Eugen Weinberg (2011) and Natalie (2011). The demand for gold is also coming from emerging-market nations that are accumulating foreign-exchange reserves according to Natalie (2011).

Concluding Observations

It is clear from the above analysis that in the wake of global crisis and the consequent heightened uncertainty, there has been high demand for gold from the central banks across the globe. It was found that central banks had either bought more gold or stopped selling their existing stock and India is no exception. In India’s case, while foreign reserves increased substantially over the years, the physical stock of gold as part of official reserves, however, remained stable. Eventually, gold’s proportion in the total foreign reserves sharply came down. In fact, even with the latest purchase of gold by the Reserve Bank, gold accounted to just around 7.9 per cent¹¹ of the forex reserves. This is very small when compared with a sizable holding by a number of central banks in advanced countries and even some EMEs as pointed out above. In that context, India’s purchase of gold as a diversification strategy is fully justified and is in line with the global trend and still there is scope to increase its holding.
What constitutes the ‘optimum level of gold’ for India is, of course a difficult question to address and unfortunately even international experience is scarce on this question. However, there is strong economic rationale to hold sufficient quantity of gold as part of official reserves, especially during the uncertainty such as the recent global financial crisis going by the historical experience.
India’s recent purchase of 200 tonnes of gold, apparently, did not cause any aberration on the international gold price trend, probably, as gold was not bought from the open market. Similar method can be followed even in future, preferably in smaller quantities. Further, as India is a depository of huge private gold holdings, this can be channelled into official reserves especially those available in the form of coins and biscuits. This will also provide opportunity for the private holders to liquidate gold without much loss as presently banks are not permitted to buy back gold from the public.
In the context of increased degree of uncertainty, especially when the U.S dollar became subject to tough challenges when U.S. attempted to salvage its economy by pumping in with heavy stimulus packages, there was a fear that it may accelerate the process of depreciation of the dollar. This in turn threatened the safety of many country’s dollar-denominated assets. Over and above, the recent downgrading of the U.S credit rating from ‘AAA to AA+’ coupled with the ongoing ‘government debt crisis’ among select European countries pushed up the demand for gold from central banks in general. In these situations, gold continued to maintain its value and therefore it is considered to act as a hedge against loss of wealth.
Thus, the recent global financial crisis, only reiterated that gold as part of foreign exchange reserves continued to play a key role in the macroeconomic management devoid of its erstwhile purely monetary role.